Great Debates: Diversification

One of the most common pieces of investing advice given by financial professionals, right behind using tax-advantaged accounts and dollar-cost averaging, is to diversify your holdings.  The argument is pretty simple: by holding a variety of investments, and multiple investments of each kind, you can ensure that one bad stock/bond/REIT/whatever you are holding will not do huge damage to your portfolio.

Of course, as with virtually every piece of investment advice, there are dissenting voices.  One noted one is Robert Kiyosaki, the author of Rich Dad, Poor Dad, who refers to diversification as ‘de-worse-ification’.  His main argument is that attempts to diversify cause people to simply buy blindly and pray that their holdings rise, rather than properly investing.

What’s the truth?  As with most financial debates, there are pluses and minuses to diversification.  In an attempt to counteract some of the prevalent wisdom, let’s start with the minuses:

1) Blunts the Top Performers – One of the biggest flaws with diversification is that, by holding tens, hundreds, or even thousands of individual investments, you aren’t able to benefit from the full growth of the top performers.  If you have a single stock that doubles in price over the course of a year, you will have nearly doubled your money (after expenses); if that stock is one of a thousand held in a mutual fund, the growth of that stock will be averaged with the gains (and possible loses) of all the other stocks, greatly diminishing your returns.

2) Leads to Overconfidence – Another problem with diversification is that it can lead to thinking, ‘if I have enough different holdings, there’s no way my portfolio can decline.’  Unfortunately, if 2008 taught us nothing else, it’s that even being diversified can’t always protect you; sometimes, all the investments within an asset class decline, and occasionally many asset classes are hit simultaneously.  There are limits to what diversification can do to protect your assets.

3) It’s Boring – The last problem is purely psychological; while holding a diverse group of mutual funds makes for a good investment strategy, it’s not the most exciting topic to discuss over cocktails.  The negative effects can extend beyond simply making you less popular at parties; if you are not interested and involved with your investments, you might not give your portfolio the proper scrutiny it deserves, and could end up with a portfolio that is far from your desired allocation or investments that are completely inappropriate for you.

So, there are some drawbacks to diversification.  Still, there must be reasons why nine out of ten (or more) financial advisers recommend diversification.  So, what are they?

1) Blunts the Low Performers – The inverse of the first disadvantage of diversification, which smooths out your returns in general.  While it decreases what you could get with a proper investment in a high performing security, it will also increase your returns over the worst performing assets in the class.  It also prevents the worry and trouble caused by bankruptcies; if the company that goes bankrupt is only one of the hundreds you are holding, the damage to your portfolio is likely to be minimal.

2) Makes Investing Easier – Another big advantage of trying to invest diversely is that, thanks to products like mutual funds and ETFs, it’s easy to find diversified investments that meet your asset allocation.  Plus, it’s usually is less trouble to track the performance of a few broadly invested funds than to individually track dozens of stocks or bonds.

3) Tends to be Cheaper – Interestingly enough, thanks again to mutual funds and ETFs, it actually is cheaper (usually) to get a highly diversified investment than a more concentrated one.  The abundance of no-load mutual funds and low cost brokerages makes it inexpensive to acquire and hold many diversified investment, whereas the commissions of acquiring even a small portfolio of individual stocks will add up quickly.

Given these relative benefits, what’s the best way to approach diversification?  My advice remains the same as when I discussed how to build an investment pyramid.  First, start by creating a set of broadly diversified investments; that way, you should have a good base to build on.  Then, once you are diversely invested, you can consider putting a portion of your money into individual stocks (say twenty to thirty percent of your overall assets).  This approach allows you to gain the benefits available with individual stocks, while avoiding many of the associated problems.  You can have your cake, and eat it too!

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