From financial advisors, mutual fund industry, media, personal finance bloggers, and every one in between, there is a consensus that diversification is essential for the best investment portfolio you can construct. Nothing can be further than the truth. The fact is, with the state of the investment industry today, your portfolio is very likely to be over diversified than under diversified. After a certain point, over diversification does not add any benefits to the portfolio, but it does take away from the potential rewards.
If You are Risk Averse, You Should Not be Investing in Stocks – Period
Investing in stocks is the same as investing in businesses on the expectation that the business will create value for the shareholders. Businesses create value by taking risks. This is the whole essence of a market economy – the rewards come in proportion to the amount of risk that is taken. Good businesses take intelligent risks, and those that do not go out of business eventually.
Good businesses also are keenly aware of the market dynamics, adjust their practices accordingly, and take on projects that minimizes overall risk profile of the business at any given time as much as possible. They also pursue new product lines and markets in search for value creation and risk reduction.
Investors in the stock market need to understand that if a business does not take risk to grow shareholder wealth, it is not worth investing in. There is no such thing as steady guaranteed returns with no risk. If that is what you want, you are better off in short term or high quality bonds and money market instruments.
See how herd psychology affects your returns
Diversified Investments Do Not Even Address All Risk
Diversification, if done well, reduces the correlation between different assets so the volatility of the overall portfolio is moderated. Which means that if one stock in the portfolio drops significantly, the other non correlated stocks that do not drop as much or increase in value will help the total portfolio avoid the extreme in the decline. Of course, it also works on the flip side – if a stock gains appreciably, the overall portfolio will not gain as much due to other stocks in the portfolio that have not performed as well. Diversification reduces portfolio volatility, so you can sleep better at night.
It does not increase your returns, but it just might decrease it. If you are a believer in diversified investments, and invest in say 100 different stocks, you have probably not done the amount of research and due diligence you should have done before investing in these stocks. It is also not possible for you to effectively monitor each stock in your portfolio. Add in your transaction fees and you have just traded some volatility in return for a portfolio that does not perform as well as it can.
And worse of all, no amount of diversification will save your portfolio from the “market risk”. If the entire economy goes down hill, your portfolio will as well.
Over Diversification – Boon for the Mutual Fund Industry
There are some types of mutual funds that rely on the good old stock picking skills to build a focused portfolio of names that they have a great deal of conviction in. The rest of the industry, and this being the majority, relies on diversification to avoid losing to the index badly. Some years they do better and some years they do worse. On the whole though, there is not much to differentiate one mutual fund from another, except for the fees and expenses.
Most investors fear losing money more than they fear not making money. Diversified investments promise less risk. And of course, mutual funds are great for diversification as they pool money and reduce costs of building a diversified portfolio. Lack of performance is explained away as an overall economic condition that the managers have no control over.
Put it another way, most investors are paying mutual fund managers for the privilege of running a ship that they can’t control.
The situation is similar with financial advisors and the media. No one wants to invest time and research to build a great performing long term portfolio if it means sometimes the portfolio might under perform the market significantly. So every one settles for the mediocre.
Buying Value Reduces Risk And Improves Performance
It is well documented that value investing outperforms growth, and small cap stocks outperform larger company stocks. In fact small cap value stocks deliver better risk adjusted returns than all other asset classes. When you narrow down your investment selection by applying small cap and value filters, the selection is understandably going to be smaller. A 10 – 20 stock portfolio delivers adequate diversification if the stocks are chosen from diverse sectors. This helps moderate the portfolio volatility. Focusing on value and demanding a sufficient margin of safety reduces risk and increases performance over long term.
This also keeps your portfolio manageable so you can properly research and monitor the businesses you own. It does mean more research and analysis to construct a focused portfolio but the rewards of spending some time upfront in due diligence and stock selection can be considerable.
Keep in mind that stocks are not the only investments available to you. You can get much better diversification by investing in assets that are less correlated to the stock market. For example, real estate is one such asset class.
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