Do you remember the fairy tale about Goldilocks and the three bears. One bowl of porridge was too hot. Another was too cold. The third one was just right. The tale, first published in 1837, also applies to the critical investment process that is known as diversification.
- Too little diversification and you are exposed to the risk of large losses
- Too much diversification and you negate the impact of higher performing investments
- Ideal diversification is subject to taste that is based on your tolerance for risk
Do not under-estimate the importance of this investment decision. It may have more impact on your future performance than any other financial decision you make for your assets.
What is Diversification
Diversification, aka asset allocation, is the process of investing your assets in multiple asset classes: Stocks, bonds, real estate, domestic, foreign, etc. Why diversify? You do not have a crystal ball that can accurately predict future performance.
- Increase Performance: Diversification increases your odds of being invested in higher performing asset classes
- Reduce Risk: Diversification reduces the amount of money you have invested in underperfoming asset classes
Don't be mislead by sale pitches. Risk tolerance is your willingness to incur losses in your quest to earn higher rates of return. Most investors have a moderate tolerance for risk. That is, they are willing to take some risk to earn higher returns, but they do not want to take so much risk that they are exposed to big losses.
- A young investor may allocate 100% of his assets to common stocks
- A senior investor may limit his common stock exposure to 25%
Layers of Diversification
There are five primary layers of diversification that impact the performance of your assets. Diversification can be by:
- Number of money managers who execute different strategies
- Domestic versus foreign investment classes
- Stocks versus bonds and other asset classes
- Industry groups: Technology, energy, retail, etc.
- Individual securities: IBM, HP, Cisco
Too Much Diversification
There can be too much diversification. For example, your financial advisor recommends eight mutual funds. Each fund purchases 100 equally-weighted securities. You end-up owning shares in 800 companies. If one of your holdings is a big winner, its performance is diluted by the other 799 securities.
- It has very little impact on the performance of your portfolio
- You are so diversified you are a closet index fund
- Your performance is driven by the market and not by individual securities
The other extreme is to invest your assets in 25 securities. You believe these securities will deliver superior performance compared to all other securities. Each holding represents 4% of your assets. You should have a high tolerance for risk when you invest in a concentrated portfolio.
- You will have stellar returns if you picked the right stocks
- You will have significant losses if you picked the wrong stocks
Diversification is a critical decisions that is driven by your tolerance for risk. In an ideal world, you diversify enough to minimize your risk of large losses, but you do not diversify so much that you completely dilute the impact of higher performing investments.