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RSS FeedPortfolio diversification: Positive or negative?
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| Negative | 15% | 34 votes | Total: 223 votes | |
| Positive | 85% | 189 votes |
Negative
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Some of the wealthiest and risk adverse men and women in the world do not attempt to diversify their portfolio. Quite the opposite, they focus their investing into one specific area of the market. There are many reasons for this which a short article will not allow for me to give an explanation justice, but we shall attempt to provide some of the answers to those that we can assume are still novice investors.
What are the cons against investing a diversified portfolio? Diversification tends to produce an optimum outcome in a rising, or bull, market where the standard indices are increasing overall. In such bull markets, the only way to match the market or follow it is by buying the most accelerating stocks and continue pumping those stocks until something like what happened in 2000 and in 2008 occurs and you are scrambling to pick up the pieces. This gives rise to new mutual funds that will diversify over the index, managed by brokers that are more interested in making a commission instead of making their investor money, and thus will not be as informed about the stocks that the investment has allocated. Knowledge is power in the market and the market loves someone with zero power.
When your focus is like a laser and you become so well rounded in the field that you intend to invest in, you have a better chance of dominating that market. Take Donald Trump for example, although he has broken out into different realms of investment, he began and created a impressively successful real estate portfolio. He focused his attention into one specific area that he understood, that he was even taught by others in his family, and made educated decisions in order to hedge his bets against the potential negative outcomes. Another example is Warren Buffet. He too has created a portfolio into many different areas, but he did not invest in the company that he purchased until he had a thorough understanding of that company.
Focus investing demands that the investor become educated in the investment that he or she is interested in. It is requisite that you understand the day to day activity of the market, business, or entity that you intend to invest in. Understand the numbers of their business portfolio, both past and present. With the limited knowledge you will obtain in diversification, you may get some winners, but you will get many losers, and your winners will only outweigh your losers in a bull market. Should you focus invest, the probability of selecting a profitable investment will dramatically increase.
Learn more about this author, Matthew Bon.
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Positive
Like any generality, one can't say if portfolio diversification is a positive or a negative for every investor. After all, Warren Buffet is famous for saying that 99% of his wealth is tied up in in Berkshire Hataway stock, and this strategy clearly has worked for him. It has also worked wonders for people like Bill Gates, J. P. Morgan and The Rockefellers to name but a few.
It goes without question that great wealth is an outcome of not diversifying.
So maybe the question shouldn't be "Portfolio diversification: Positive or negative", but rather "Portfolio diversification: Do you feel lucky?"
In other words, do you believe yourself to be as fortunate as a Buffett or a Gates?
But before you answer this question let's flip it around. Let's see what happens if you're not as lucky as these billionaires.
Many firms encourage employees to purchase shares in their company. And before the collapse of both World Com and Enron, many unfortunate individuals had not only their pension but also large amounts of personal savings invested in company stock. And for a while, this was a great deal. After all, these companies were flying high, the stock price increased regularly and everyone was happy.
The company was happy because it funded large portions of employee pensions from shares it could issue itself. Employees were happy because they were paid bonuses in shares, and were also encourage to purchase shares at a discount, shares that almost always seemed to increase in value.
And you know for a while it worked out well. Everyone was happy. Share prices were regularly increasing, paper wealth was increasing, and the future looked bright. Very bright.
But of course the collapse of both firms changed all that, with tens of thousands of people sadly losing their jobs. And they were the lucky ones, as even worse, large numbers of former employees - many of them paper millionaires, with nearly all their personal wealth tied up in company stock - lost everything. Jobs, savings, pension all suddenly wiped out.
These unlucky individuals - investors by definition - harshly learned the value of diversification.
Sad real world examples such as these aside, finance as a discipline has known since the 1950's that a carefully constructed - diversified - portfolio has two very attractive qualities: lower volatility and the same or higher returns.
In other words, changes in the value of a diversified portfolio tend to be smoother, both increases as well as decreases. And diversified portfolios will, over time, earn more than an un-diversified portfolio. In finance speak, diversified portfolios have higher returns.
But let's take a closer look at these qualities, and without going into the underlying mathematics.
We all know there are many different things - assets - that one can invest in. Stocks, bonds, real estate, commodities, antiques, art, the list is potentially endless. Each of these possible investments represents what's called an "asset class".
And we also know that some investments - the carefully picked ones - increase in value over time. But anyone who has invested knows such changes in value aren't always to the upside. In other words, shares increase in value, and shares decrease in value. Real estate goes up, real estate goes down. Over time we do see investments increase in value, but rarely only in one direction; they prices bounce about somewhat, and not all at the same time and in the same direction. In other words, the prices of different asset classes tend to behave differently.
The key concept here is correlation: if we construct a portfolio of investments that have a low degree of correlation, while one asset class increases in value others might decrease. And vice versa.
A diversified portfolio benefits from low asset correlation because overall changes in the portfolio's value are mitigated. They aren't as sharp and pronounced as those observed from an un-diversified portfolio, as changes in each asset class cancels each other out.
Meanwhile, the diversified portfolio increase in value much faster than an un-diversified portfolio as the investor acquires assets that might otherwise be ignored.
For example, an un-diversified, 100% stock investor would have missed out on much of the real estate boom or the recent oil price spikes (exposure acquired by means of REITS or ETFs aside). These asset classes and their returns would have been overlooked by the un-diversified investor.
And even now, with real estate collapsing the diversified investor would benefit as non correlated assets classes would compensate for this erosion of wealth.
Clearly a diversified portfolio offers many qualities an un-diversified portfolio lacks: lower volatility and the same, or perhaps higher returns.
But a diversified portfolio lacks something the un-diversified portfolio needs: luck.
So an investor choosing between a diversified and un-diversified portfolio really must first ask themselves: do I feel lucky?
Learn more about this author, Dave Coker.
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