Diversification can be a great way to protect your investments – if you don’t make these diversification mistakes!
Today, as I write this, we’re in a crazy bull market – aka, the stock market has been on steroids. There is growth to be found literally everywhere.
In an upward trending market, diversification gets no love. There is no reason to diversify if all stocks can only go up.
But diversification is not a strategy for good times.
If the stocks you picked only went up, you would not ever need to diversify.
Warren Buffet is often quoted as being against diversification; he claims that “diversification is protection against ignorance.”
Sure, if you knew everything about the company and have the power to influence the company’s decisions, you too would think that diversification is unnecessary.
We, as little investors, don’t have full access to the companies we choose to invest in. As a seasoned investor, Warren Buffet has the ability to get a closer look that we may not have access to or the expertise to analyze.
Diversification protects us when we guess wrong.
If you’re a beginner investor or prefer to set it and forget it with your money, then investing in index funds or diversified ETFs is the right move for you.
Investing in an index fund or diversified ETF is a great strategy for diversification.
If you plan to manage your own investment portfolio, then understanding the role of diversification in your portfolio is an important lesson.
How to diversify your investments
There are many strategies and perspectives to diversify your investments. The ultimate goal is to make sure that all your investments don’t move in the same direction at the same time.
Some popular strategies to diversify your investments:
- Asset class – stocks, bonds, real estate, crypto
- Geography – US, Canada, emerging markets
- Industry – a variety of industries that don’t rely on each other
Diversification is for reducing risk, not for increasing returns.
Why bother with diversification?
Reduce risk
The ultimate goal of diversification is to make sure that all your investments don’t go down simultaneously.
If you have $100 to invest and only invest $100 in Company A, then your portfolio with go up and down based on the returns of Company A. if company A lost 10%, then your investment would be worth $90.
Instead, if you divide your $100 by investing $50 in Company A and $50 in Company B, then you are not placing the risk of your entire portfolio on Company A. If company A again lost 10%, but Company B gained 10%, then you would still have $100.
Smoother Returns
A lot of people talk about volatility. In practice, volatility measures the swings of your portfolio. Are your investments going up 10% one day, down 15% the next?
The goal of diversification would be to smooth out your gains and losses so that there aren’t major ups and downs.
Reduce stress
If investing in the stock market makes you lose sleep and causing you stress, it’s potentially a sign that there is too much risk in your portfolio.
A well-diversified portfolio that doesn’t swing up and down on a whim can be useful in reducing financial stress.
Common Mistakes in Diversification
Over-diversification
It is possible to diversify too much to the point that you are not benefitting from the rewards of diversification, and in fact, losing returns from diversifying too much.
Some tips to avoid over-diversification:
- Hold a manageable number of stocks
- If holding funds, and ETFs, consider if there are too many overlapping positions
Too many stocks
One way to diversify is to hold more stocks. But if you are managing your own portfolio, it can be hard to manage too many stocks administratively.
It is hard to track their performance and decide if you should continue holding them.
An often-quoted study from 1970 claimed that “95% of the benefit of diversification is captured with a 30 stock portfolio”. That study is potentially outdated and should not be construed that owning 30 random stocks means that you now have a diversified portfolio.
However, it does show that it is possible to diversify your portfolio by owning the right subset of stocks without holding a substantially large number of stocks.
Not a real diversification
There are many facets to diversification. You can achieve diversification in your portfolio by paying attention to different factors such as:
- Industries of the stocks you own
- Asset class – stocks, bonds, real estate, crypto
- Geograpy – US, Canada, emerging markets
If your source of diversification is holding a variety of stocks (say 30), but all those companies are in the same industry, then you’re not diversifying your risk.
There are risks that all of those companies would be exposed to – whether that is a change in regulation, or maybe there is no more demand for their product. And your portfolio will be immensely exposed to that risk.
Not rebalancing
A lot of times, we get excited to set up our financial selves. We are inspired to believe that if we are set up for success if we’ve managed our risk.
But then we forget to continue monitoring it on an ongoing basis.
If, for example, you set up a target allocation of 40% technology stocks to start. Over time, maybe these stocks grew faster than the rest of the market. They may now be overrepresented in your portfolio.
If you manage your own stock portfolio, checking it to rebalance is an important exercise. Set up a schedule to remind yourself to check quarterly, or at least annually, to ensure that you are still comfortable with your set target allocations.
Getting emotional
Greed and fear are both emotions that can hold us back from our financial plans.
Maybe you decide to put a large part of your portfolio in crypto because you believe that is the future. And you let go of your plans to diversify.
Playing into FOMO can kill the best-laid financial plans.
Pay attention to your biases and emotions when it comes to your investments so that you can make sure that you’re continuing to work towards financial success.
Final Thoughts
The stock market is full of risk. There is no such thing as a guaranteed investment.
Diversification is a great strategy to reduce the downside risk of your portfolio.
In good times, diversification may look like a bad strategy. But don’t forget that your diversification is there to protect you in the event the market reacts in a way you did not expect.
Understanding your portfolio’s risks and the purpose of diversification can help you avoid making common mistakes investors may make when attempting to diversify their portfolios.
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