This is the first instalment of a two-part series on portfolio diversification. Part 1 examines the advantages and disadvantages of diversification in investing while Part 2 touches on ways you can diversify your portfolio.
Investing is a perpetual balancing act of risk and reward that requires careful planning and implementation. One way to maintain balance is to spread your investments across a variety of assets. This strategy is known as diversification.
In the world of investing where uncertainty is the only certainty, diversification plays a vital role in reducing risk and increasing portfolio stability. Nevertheless, excessive or poorly executed diversification may result in a portfolio that is worse off rather than improved. You are also likely to incur more costs.
1. Advantages of Portfolio Diversification
1️⃣ Risk Mitigation
Venezuela, home to the world’s largest proven oil reserves, has suffered prolonged economic meltdown marked by hyperinflation, social unrest and an exodus of more than 7 million people. One of the causes of the crisis is over-dependence on oil, which accounts for almost all of the country’s exports, at about 95%.
Due to a lack of economic diversification, petrostates like Venezuela are vulnerable to boom-bust cycles. They tend to prosper when oil prices are high, but struggle when prices plummet. Doesn’t exactly inspire confidence, does it?
Investing is quite similar. When a portfolio lacks diversification, it’s also vulnerable to boom-bust cycles and market volatility. To mitigate the risk of being left high and dry during tough times, it makes sense to limit your exposure to any one type of asset by diversifying your investments. This way, if one investment performs poorly, the better performing ones can help to offset the losses and reduce the negative impact on the portfolio. Makes sense, right?
Of course, diversification does not guarantee that you will not lose money. There’s no such thing as a guarantee when it comes to investing — I’m sure you know that already. However, diversification can lower the overall risk of your portfolio so that you are more likely to get consistent returns and make money in the long run.
Check out: Investing During a Recession: What You Need to Know
2️⃣ Growth Opportunities
Besides managing overall risk, a well-diversified portfolio also opens up opportunities for growth by exposing you to different asset classes, sectors and geographical regions.
For instance, although many stocks experienced drastic decline during the Covid-19 pandemic, some sectors and companies saw significant gains due to shifts in consumer behaviour, as well as increased demand for certain products and services.
If you had invested in pharmaceutical (e.g. Pfizer, which was at the forefront of developing Covid-19 vaccines) or e-commerce (e.g. Amazon, which was flooded with online orders of essentials like toilet paper… ahaha), you would have benefited from their positive performance.
In the event of a downturn in one of the sectors, your diversified portfolio will still be better positioned to weather the storm compared to a portfolio that is concentrated solely in one sector or company.
Advance Your Learning: Income diversification is also a crucial strategy for achieving financial stability and abundance. To learn more, check out Beyond 9-5: Discover the 7 Income Streams for Lasting Wealth, Multiple Income Streams: Weighing the Pros and Cons and Why Having Multiple Streams of Income May Be Overrated.
2. Disadvantages of Portfolio Diversification
1️⃣ Over-diversification
While diversification is a widely endorsed risk management strategy (most if not all financial advisors will tell you to diversify your portfolio), there’s such a thing as over-diversification.
The term “diworsification” has been used by many including legendary investors such as Peter Lynch, Warren Buffett and Charlie Munger to describe inefficient diversification. Said Munger in 2021:
“A lot of people think if they have 100 stocks they’re investing more professionally than they are if they have four or five. I regard this as insanity. Absolute insanity. I think it’s much easier to find five than it is to find 100. I think the people who argue for all this diversification, by the way, I call it ‘diworsification,’ which I copied from somebody. And I’m way more comfortable owning two or three stocks which I think I know something about and where I think I have an advantage.”1
I couldn’t agree with him more.
Having a large number of stocks does not necessarily mean you have a well-diversified portfolio. In fact, too much diversification can actually complicate matters, making it challenging and time-consuming to manage, and it may also dilute potential returns.
Rather than indiscriminately adding numerous stocks without a thorough understanding of each company’s fundamentals, you should be discerning and narrow down to a few areas where you have expertise.
With the benefit of hindsight, Mr Wow and I would have done better if we had been more selective when we first started our investment journey.
2️⃣ Higher Costs
All investments incur costs such as brokerage fees, custody fees, foreign exchange fees and taxes. When you diversify your portfolio, there will be more buying and selling transactions, so your costs will naturally go up as well. These costs can eat into potential returns, especially for retail investors who have limited resources or trade in small quantities.
One way to reduce your costs is to minimise portfolio turnover by adopting a long-term buy-and-hold strategy. That’s not a bad idea since the market has historically shown an upward trend over the long term. Do NOT try to time the market by frequently buying and selling assets. It’s extremely difficult to pull off and will only increase your costs.
You can also opt for low-cost investment options such as index funds or exchange-traded funds (ETFs). These vehicles typically have lower expense ratios compared to actively managed funds.
Above all, taxes can take a substantial chunk out of your profits, so make sure you have a good understanding of tax implications and stay informed about changes in tax laws, which could possibly be advantageous to you. It’s advisable to practise tax-efficient investing by making the most of tax-exempt or tax-deferred accounts.
Check out: Understanding Index Funds: Does the Tortoise Really Win?
To wrap up, here are the key takeaways:
- Exposure to investment risk cannot be entirely eliminated, but diversification can help to minimise it.
- By spreading investments across different asset classes, sectors and geographical regions, diversification opens up opportunities for growth and helps to neutralise the impact of poor performance in any single investment.
- Over-diversification, aka diworsification, can lead to complexity and diminish potential returns. Instead of spreading your investments too thinly, it’s recommended that you concentrate on sectors and companies that you understand well.
- Diversification increases the frequency of buying and selling, which can result in higher costs. You should therefore consider the associated costs carefully and weigh them against the potential benefits.
It’s clear that diversification has its limitations and is not a one-size-fits-all solution. While it serves as a prudent risk management strategy, its effectiveness hinges on thoughtful planning and execution.
To harness the potential benefits of diversification, you should approach it with a discerning eye and strive to find the right balance for your situation while staying vigilant in the face of evolving markets.
We will explore the different ways you can diversify your investment portfolio in my next article. Till then, happy investing!
Sources:
- Charlie Munger: It’s ‘absolute insanity’ to think owning 100 stocks instead of five makes you a better investor: https://finance.yahoo.com/news/charlie-munger-on-value-investing-and-the-crisis-in-wealth-management-114327424.html
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