Don't Fall for Fake 401(k) Diversification

NEW BERLIN, Ill. ( TheStreet) -- Sometimes we fool ourselves. Sometimes we think we're doing the right thing, when in fact the result is that we're not at all doing what we think we are.

I'm talking about your investment diversification. When you started your account, you were probably dazzled by the array of choices: a stable-value fund, three large-cap stock funds, a midcap stock fund, an international stock fund and two different bond funds. Recalling an article you read somewhere, or maybe your co-workers talking about around the water cooler, you knew you needed to split your investments among many allocation options. Wanting to do this diversification thing right, you split your 401(k) contributions with one-eighth in each of the funds available. You're well-diversified now, right?

Not even close, bucko.

Just because you have investments split among several funds doesn't mean you're diversified.

Just because you have your investments split among five (or seven, or nine or what have you) different investment choices doesn't mean you are diversified. Recently I reviewed a 401(k) account in which the participant had chosen, all within the domestic equities class, eight different mutual funds. All eight were fine funds, with relatively low expenses and good diversification.

The problem is that the eight choices made were roughly equal to one: a total stock market index choice. The participant could have accomplished the same result by choosing only one fund, greatly simplifying the account and, as it turns out, reducing internal expenses dramatically.

The real problem though, is that the participant had not allocated any of the account to fixed income, or international equities, or real estate, or any other asset class that gave the account true diversification.

Correlation
Welcome to correlation, a statistical measure of how two securities move in relation to each other. It's pretty complicated, but the gist is this: If two securities are perfectly correlated, when one moves up or down, the other moves up or down in perfect relation to the other. Such securities are said to have a correlation coefficient of +1.

On the other hand, if one security moves up and the other moves down (and vice versa, by the same proportions), they are said to be negatively correlated, with a correlation coefficient of -1.

Lastly, if one security's movement has no relationship whatsoever to the other security -- that is, any particular movement by one of the securities may or may not result in a movement in the same direction, the opposite direction or no movement at all. These two securities have a correlation coefficient of zero.

Most pairs of common securities fit somewhere along the spectrum between +1 and zero, since very few are perfectly correlated. Negative correlation is typically found in hedge funds -- often a costly, complex sort of asset to hold, being designed to work opposite of the general market movements.

Hopefully this makes it clearer why we want securities in our portfolio that are not correlated closely to one another. Having such pairs of securities spreads our risk of any single market event having an adverse impact on everything in our portfolio.

How?
What if you don't have those kinds of options available in your 401(k)? This is part of why it can be useful to have other savings plans in your scheme, such as a Roth IRA or a taxable account. With these other accounts, you can have the flexibility to invest in whatever asset classes you like.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.