The importance of diversification is stressed by many financial experts. Investors are constantly reminded that a well diversified portfolio is the key to minimizing risk. This constant reminder that diversification is good can lead some investors to over diversification. Over diversification ultimately leads to a state called diversiconfusion.
What is Diversification?
In order to create a well balanced portfolio that can withstand many market cycles one must diversify his or her portfolio. In financial terms diversification means investing in a variety of assets in order to systematically reduce risk. One’s overall portfolio should be diversified among different asset classes. One can diversify by allocating investments into stocks, bonds, commodities, real estate, alternative investments, mutual funds, etc.
Why Should I Diversify My Portfolio?
The main reasoning behind diversification is to minimize risk. It is important to understand that diversification does not eliminate risk, but if done properly it can minimize it. The goal of diversifying one’s portfolio is to maximize the long term return on one’s portfolio, while beating the market’s return.
How Can I Diversify?
There are several different techniques to creating a well-diversified portfolio. In order to diversify create a portfolio that has aspects that are negatively correlated. For example, in the case of securities consider purchasing securities in different industries. Other criteria to consider in the case of security diversification are to choose securities with different company size, sector, and country. Having a portfolio with negative correlations will cause one’s portfolio to react differently to various changes in the economy. Assets that historically react differently during market cycles will allow one to offset the impact of poor market performance.
What About Mutual Funds?
Many investors make the mistake of solely investing in mutual funds, because they believe that this will lead to a diversified portfolio. However, this is generally not the case. Many mutual funds may invest in 100 different companies. Nevertheless, this is not optimal diversification. This is due to the fact that many mutual funds are industry specific; meaning that the mutual fund invests in many different companies that compete in the same industry. Industry specific mutual funds are highly susceptible to changes in the market cycle.
What is Over Diversification?
Over diversification is creating a portfolio that encompasses too many different stocks, bonds, mutual funds, etc. to the point that one will achieve minimal to negative returns. There are many different reasons why over diversification can negatively impact one’s portfolio performance. For example, buying too many stocks prevents one from undertaking the necessary due diligence when selecting a stock. In addition, over diversification can lower risk. However, lower risk is also usually accompanied by lower returns.
What is Diversiconfusion?
Diversiconfusion is the state of confusion as a result of diversification. Many people are often left perplexed by their banking, brokerage, cash flow, and accounting statements. Over diversification does not help with this confusion. Spreading your money over many places makes it difficult to organize, monitor, and understand. To avoid diversiconfusion one should communicate with their financial advisor and ask many questions to clear up any confusion with his or her diversification. The right financial advisor will be able to communicate to you about your financial needs not through you.
What Do the Experts Say?
According to Warren Buffet, “Wide diversification is only required when investors do not understand what they are doing”. Warren Buffet is stating that people who over diversify simply do not understand what they are investing in. People who over diversify usually will not lose much, but they will not gain much either.
Diversification is highly useful for investors in order to minimize the risk of investing. However, over diversification can cause diversiconfusion, which can negatively impact one’s portfolio. The right financial advisor will be able to help investors diversify their portfolio to create optimum returns with minimal risks.
Right Financial Advisor’s Nick Bredow, contributed this report.