The Great Diversification Myth

Most of us have the benefit of receiving expert advice in most aspects of our lives. Due in large part to capitalism, we can find an ophthalmologist to advise us on our eyes and vision, a computer consultant to help us with our computer, and even a wedding planner to handle our upcoming nuptials. We have come to believe that we can, and should, seek professional advice for any decision we make—this includes both big and small matters.

 

What About Investment Advice?

asset management

Is diversification the best strategy for you to reach your goals?

 

Investing our retirement money, our children’s and grandchildren’s college fund, or our legacy fund dollars is no small matter. We need to carefully develop a plan for structuring our investment portfolio in order to protect it the best way we can while providing a level of return on investment that is in line with our needs and goals.

Most people use professional investment advisors or mutual funds to manage and oversee their portfolios. They do this through their IRA accounts, their 401(k) accounts and their individual brokerage accounts. They assume that the people managing their funds have their best interest in mind when handling their investment dollars. We can debate for weeks as to whether or not this is true, but the facts remain that most of their performance results over extended periods of time do not prove this to be the case.

Before we go any further, let’s define a couple of words: portfolio and diversification.

According to Investopedia, a portfolio is a “grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts.”  It doesn’t matter whether we have $5,000 or $5,000,000—our collection of financial assets makes up our “portfolio.” And this portfolio is all we have to work with in order to build for our future or our children’s future.

Diversification is defined as a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

 

The Diversification Myth in Action

Educating ourselves in order to understand how to correctly apply correlation rules within our investment accounts and structuring our portfolio to take correlation into account is no easy task.

Some studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks or other investment types will yield the most cost-effective level of risk reduction. But keep in mind that the goal assumed by these studies and models is to reduce risk not to maximize return. Can you imagine having to continually learn and keep up to date with about 25 or 30 different stocks or other investment types at any given time and to fully understand and recognize when conditions have changed to make this stock or investment type no longer appropriate?  The large majority of individual investors are simply not equipped with the time or resources to make this a reality.

Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds, and particularly index funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with what they might think is an inexpensive source of diversification.

However, the cost can be seen in the reduced overall performance of our mutual-fund based portfolios.  Most of us ignore the amount of dollars that are being sucked out of our portfolio by management and advisory fees. Many of these fees and expenses are hidden from us. These costs are staggering and obscene and they can keep you from realizing your goals and dreams.

We even show in our stock investing course why fees and missed opportunities from mutual funds or money managers can suck out 70-80% of your retirement account when all is said and done. This is such an outrageous number that it’s almost too hard for many to believe. It’s certainly not something you’ll hear your commissioned financial advisor or stockbroker tell you. But it’s the truth, and there are steps you can take now to stop it.

 

What the Diversification Myth is Really Accomplishing

Conventional financial wisdom teaches us to spread our investments around instead of investing all of our money in one type of investment. For example, many of them teach that when investing in mutual funds, we should allocate our funds between growth stock funds, small cap funds, large cap funds, bond & income funds, and international funds. The logic behind this strategy is simple—if one or more type of investment fund is performing poorly, perhaps some of the other funds’ performance can bring up the average return (or possibly to reduce the losses caused by the non-performing funds.)

diversification myth

Is the diversification myth keeping you from the kind of results and future you’ve always dreamed of?

Warren Buffet said, “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”  Having all of our “eggs in one basket,” might not be the most secure way to invest our money, but diversification, and certainly over-diversification, can be just as—or more—insecure.

Many investors spread their money around into various types of investments and end up with half of them doing well, while the other half is not doing so well or even losing ground. This results in your overall annual growth rate to be very low—probably mediocre at best. This is no way for us to reach our goals.

 

Learn How to Invest—the Right Way

The problem in trying to invest among all investment classes and types is that it is hard to learn what we need to know for every type of asset we are investing in. The more we spread our investment dollars around, the more we are exposing ourselves to ignorance of each specific type of investment. It is a challenge for most people to learn even one investment class very well let alone many different classes of investment vehicles.

If we look at our overall investment portfolio and have an average rate of return that’s less than 6%, we’re not even making enough to keep up with taxes and inflation. And that’s assuming the inflation rate doesn’t increase as a result of the current financial crisis, debt, and political environment. The diversification myth is keeping most people from reaching their true potential.

If we want to reduce risk, there’s only one way to do it and that’s through a sound financial education. That is—knowledge of what to invest in, when to buy, when to sell and when to hold on. With this knowledge, we can be selective about our investments and focus only on what we are comfortable with and what works for us.

The good news is, this level of education doesn’t take too much time—just some commitment and motivation. It can be done, and you don’t need to accept the financial stress and difficulties that you could be currently facing.

Our level of risk is directly related to our level of financial awareness and education. People like Warren Buffet don’t diversify, because they don’t need to. Instead, they choose investments based on sound knowledge which they’ve acquired and, most important, their ability to predict what will happen with the flow of wealth in the very near future. You can do the same.

Acquiring this knowledge can get you much higher returns with less risk; continuing to believe the diversification myth will get you mediocre returns, while still exposing you to substantial risk. All of this is within your reach—you just need some education and coaching—and then start to take action.

Live Your Dreams

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Randy Tudor is the VP of Investment Research for Margin of Safety Investing, LLC. He has over 35 years of experience in financial services, real estate, taxes, and accounting. He currently resides in Phoenix, Arizona, where he heads up the investment research and analysis team by focusing on companies with strong fundamentals, a durable, competitive advantage, honest and talented management, and which can be acquired for a margin of safety price.

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