I would like to clear up what I’ve seen lately as a misconception of the term “diversification” and the implication that by having multiple custodians of your money means you’re diversified.
“Diversification” is defined as a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification is important because when 1 or more of these asset classes is dropping in value, if you’re diversified, you have other asset classes that don’t move in the same direction, thereby keeping the other values in the portfolio the same or moving in the opposite direction, giving a positive return for that class.
Now, nothing in that explanation states anything about having multiple custodians as a means of “diversifying”?
So, now let’s explain what a financial custodian is. A bank, trust company or other organization, like Charles Schwab or TD Ameritrade, that is responsible for safeguarding financial assets. The custodian is the company that maintains electronic records of financial assets or has physical possession of specific securities. They do not have authority to buy or sell anything without the consent of the financial advisor.
What all this means is you can have a well-diversified portfolio with one custodian. Remember, the financial custodian does nothing other than hold those assets. So, for example – you could have 3 different custodians of your money. Charles Schwab, TD Ameritrade and a bank. Now, you have 3 investment accounts, but how do you know if you’re diversified? You could have all assets in one asset class, like the S&P 500 Index, all large companies, or all one sector of the market, or sectors that have high correlation like technology/communications. Because you have 3 custodians, or keepers of your money, you are NOT diversified.
By contrast, you could have your money with one custodian, Charles Schwab for example, allocated within all 19 academically defined asset classes. Let’s define asset classes: A group of securities that exhibit similar characteristics and behave similarly in the marketplace – i.e. US Large Cap growth companies, US Small Cap growth companies, Int’l Large Cap Value companies, Micro cap companies. So, if you truly have a diversified portfolio, there should be 19 of these asset classes.
So, now you have only 1 custodian but you are prudently diversified. You not only have 19 asset classes, but included in that are 44 countries and 12,977 holdings.
I hope that makes sense to you and clears up the misconception of diversification vs custodians.