Diversify, diversify, and diversify!
The investment field considers this a rule, sometimes to the extent of treating this as an investment law.
In order to play, you must understand the principles.
By definition, it is a risk management technique used for higher returns while sustaining lower risk. The concept is that once an investment performs negatively, the positive will counterbalance it.
Theoretical reasons to diversify:
- Reduce risk by spreading your cash in multiple ranges of securities
- Avoid cyclical or seasonal variations
- Minimize variance
When you play roulette, do you put your money in red, black, odd, even or 00?
Studies and a few models advocate for a diversified portfolio between 25-30 stocks. Some even recommend that a portfolio of ten is enough if they are chosen wisely. In different cases, theoretician and mathematicians suggest 15-20 stock. The more investments are added, the better the diversification, but at a lot smaller proportions because the range of holdings increases.
Many investment corporations and portfolio managers may realize that diversification can have high costs, and they are likely to recommend mutual funds and/or exchange-traded funds (ETF). This can be why, many of the retirement plans provide multiple fund options. In several cases, like your 401(K) your cash is invested in a fund within a fund.
But how skilled are you in choosing stocks?
The securities market isn’t for those faint of heart. The foremost illustrious example used to explain diversification is the proverb, “Don’t put all your eggs in one basket”. If you do not engage in stock picking or, perhaps, have a poor track record, then, diversification should be done by all means.
What are the disadvantages of diversification?
As you can see, there is no superior rule on how diversified one ought to be. Each time we see a market crash, the media, analysts and culprits criticize that investment vehicles were improperly set up; they’re too aggressive and should have been better diversified.
There was a study by Professor Tobias Preis and collaborators on the results of diversification. Despite the fact that the analysis threads somewhat deeper into predicting major market downturns, Dr. Kenett found that “consequently, the diversification effect, which should protect a portfolio, melts away in times of market losses, just when it would be needed most.”
Many diversification strategies disregard quality or value of an investment or the price paid for it. Statistically speaking, there is a market correction every 8-10 years, where it is normal to incur a 42% unrealized loss.
Diversification is not immune to the inevitability that someone’s gains are offset by someone else’s losses.
What about owning the world?
Technically, you’d be able to purchase a chunk of any public company within the world (highly not recommended); however, owning every investment in the world is counterproductive; you would earn exactly 0% as a result of your gains counterweighing the losses.
So, what should you do?
If you believe you possess skills for stock picking, then why not build a portfolio of great companies with robust moats and valuations? You can look at details, such as the ones mentioned in valuing a business, and once thorough fundamental analysis is complete, choose a couple of investments. Otherwise, find a financial advisor who will explain their methodology and its concern with the method of investment selected. If you or the financial advisor understand how businesses operate and they create value, then why place your portfolio through diversification only to mention you’re diversified? You certainly wouldn’t go out into the world and purchase a service station, restaurant, shoe store, automotive store, supermarket and a hair salon all at one time simply to be diversified. You should purchase a business because it will sustain business cycles and be profitable within the long-term.
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