The TRAPS of Portfolio Diversification
Financial diversification is often correlated with the adage, "Don't put all your eggs in one basket". But how stable is it to carry a bunch of small baskets out to the chicken shed, fill each with an egg or two and then haul them all back to the house? Point is there are TRAPS some investors fall into when they diversify. The key is to manage all investments as one portfolio.
Diversification is the tactic of spreading invested money across a range of different holdings in an effort to avoid losses from one poorly performing investment. However, the point is not to invest in a wide range of securities that may not fit your profile just for the sake of it.
The point of diversifying is to manage risk. Why else would you diversify if that wasn't the case? When money is spread out among investments, chances are good that, in most market environments, some aspect of the portfolio will continue to grow even when other investments experience a decline.
However, past research has shown that holding too many securities can increase investor cost without delivering better returns or reducing portfolio risk. One study found that the diversification benefit is maximized when an investment holds no more than 20 to 30 different securities.
Keep in mind that thousands of mutual funds hold upwards of 100 or more securities. On top of that, many investors hold multiple mutual funds for diversification purposes. Some even add exchange-traded funds (ETFs) — another collection of securities — to the mix, as well as a variety of holdings in their 401(k) plan at work. Therefore, it’s not uncommon for investors to own literally hundreds of securities, with some of the same ones in different funds.
It's kinda like carrying dozens of baskets of eggs back to the farmhouse. When you consider diversification from this perspective, it is easy to see where investors could be doing more harm than good.
Does diversifying mean you’re more likely to earn higher returns? No. Diversification is largely a risk-management strategy, designed to protect an investor from investing too much of his or her wealth in a poor performing investment. By spreading assets over different types of investments, typically ones that do not move in the same direction with each other, the investor spreads out his or her risk of loss. The idea is that some investments should be performing well even when others drop.
Years ago, I had a hard time understanding why would anyone want to put money into different products that move in opposite directions? Wouldn't you never make any money? The reality is that most investments do go up over time. It's the type of business cycle or economic cycle we might be in at the time that determines the possible direction of each asset class.
Keep in mind that the same risk-management theory applies to ascending markets. The more diversified a portfolio, the less likely all securities experience market highs at the same time. Not only is the risk diversified; so are the rewards. That’s another cost of over-diversifying.
Many of us might understand that diversification is a sound investment strategy. But like all good ideas, it requires proper implementation. When working correctly, a diversified portfolio features ongoing growth even when some holdings are declining. It provides balance — the same type of stability required to carry a bunch of eggs in one basket.
Think of the basket as your portfolio. It would be foolish to carry 100 eggs in one basket. However, a handful of different types of eggs — chicken, duck, bantam and quail — might provide the level of diversification needed for risk management without suffering the negative effects of returns.
What about the cryptocurrency market? Should you be diversifying? Are you putting all your eggs in the basket of Steemit? The next time you place more money into Steemit, consider diversifying into a few others such as Bitcoin and Ether. It might help you sleep better at night.
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