Portfolio diversification: Positive or negative?

Negative

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by James Brumley

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As with all things, there is no absolute 'positive' or 'negative' answer to the question of whether or not a diversified portfolio is preferable. Given how investors interpret the word though - and apply the concept - the practice of diversifying a stock portfolio far too often makes matters worse than better.

There are four key reasons why specific attempts to diversify a portfolio may hamper an investor's bottom line results. In no particular order, they are...

1) There's a fine line between a diversified portfolio and an index fund. While it's nice for an an investor to assume the stocks they've picked all happen to be the best possible stocks that can be owned in their respective group, the reality is, most of those stocks will be merely mediocre. And, even the best stock in a weak sector or region is still a weak stock.

There's nothing wrong with mediocrity - the diversity will still shield the portfolio from volatility. An index fund can achieve the same result though, without all the trouble or tax liability.

2) Each new stock purchase (or sell) also drains the account when commissions are paid. One or two commissions are tolerable; 20 or 30 commissions in a short period of time may eat into any fiscal benefit of picking individual stocks.

3) Diversifying a portfolio can give a false feeling of safety, which may prevent an investor from constantly monitoring the qualities of each of their stocks. Worse, it may cause an investor to forget about their positions altogether. Even a diversified portfolio needs attention in a shaky market.

4) Allocating a portion of a portfolio to an asset or group that is known to be weak, or even suspected to be weak, is also a diversion of investment dollars that could otherwise be invested in stronger assets.

No, nobody has a crystal ball to be able to say for sure which industries are likely to lead or lag over the next few months (or even years). There are qualified opinions though. With just a little homework, even amateur investors may be able to successfully determine which areas are looking better than others for the foreseeable future.

If these realities were uncommon, and most investors could properly diversify a portfolio, perhaps a 'positive' response could be made. In light of these ongoing challenges though, many investors may be better served by focusing more on other factors and less on 'how to' diversify.

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