Portfolio diversification: Positive or negative?

Negative

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by Eli Chisholm

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I have a number of favorite sayings and quotes when it comes to personal finance, but none I hold so dear as this one, "Wide diversification is only required when investors do not understand what they are doing." Warren Buffet said that, and I think that holds just a tiny bit of clout. A lot of larger brokerage houses or mutual management companies tell the populace as a whole that diversification of investments over a large number of general stocks or industries leads to less risk of loss, since if one sector of the market drops, the others will go up and shore your nest egg. I've got another quote for that, "Risk comes from not knowing what you're doing."<?xml:namespace prefix = o ns = "urn:schemas-microso ft-com:office:office " />
Warren Buffet said that too.
Diversification of investment, in principle, minimizes risk to your portfolio. With a lack of financial education, using a shotgun method at choosing companies to buy runs the best chance of picking at least a FEW winners. Unfortunately, it also minimizes your rewards as well, since playing the 'safest' route possible forces an investor to miss out on many amazing opportunities.
Why, you might ask, is that the case? Well, nearly all amazing opportunities in the investment world start off small, or look risky to investors. Microsoft was right out of left field for it's time; who cared about a company that had a lock on personal computer licensing back then? It was laughable to consider ANYBODY with a home computer other than the exclusively wealthy. Or Amazon.com as well. It was silly, at the time, to consider people buying ANYTHING online; everybody thought Barnes and Noble or Borders would crush them. Yet now, Barnes and Noble and Borders are tailing behind amazon.com, and emulating THEM.
Neither of these would have been recommended to a person who wanted to 'play it safe' at their initial offering. Now, it seems, they are a staple of a safe, diversified portfolio.
A lot of people think they don't have the time to learn about investments, that it's too complicated, and that they are better off leaving it to other people. I, personally, am not too fond of giving my money to somebody that won't guarantee they won't lose it; if I'm going to squander my cash, I'd rather do it myself.

Some people are fond of the idea of mutual funds; they are full-packaged diversified portfolios in easy to swallow bundles. I personally hate them for a number of reasons, but the simplest way to compress all of that ire is like this: there's nothing a mutual fund does that I cannot do cheaper, faster, and more profitably. After all, mutual fund companies are huge businesses with many billions or trillions of dollars invested in the markets; any major changes they would take to get advantage of shifts in any of the markets would cause unintended ripples simply from the mass of their money.
It would be like trying to catch a trout using dynamite; you might get that fish you wanted, but the masses of fish you obliterated in your wake ends up hurting in the long run. I, and other small investors on the other hand, are able to move fluidly to take advantage of individual changes, since we are not bogged down like they and other diversified houses are. And we won't even get into their fee structure really: maintenance fee, handling fees, trade fees, capital gains fees (for every time they sell one of your stock), they just keep coming! I'd rather keep the fees, and reinvest them.
Finally, let's talk about diversification in an IRA. This topic I find imminently distressing and frightening. Not many people understand the consequences of an IRA at retirement, or what their investing practices will do to them. Most people, wanting to play it safe, have diversified their retirements, placing a little of their money in blue chips, a little in small cap, some in pharmaceuticals, some in electronics, a bit in cyclicals, industrials, etc. All at the urgings of their advisors, so that their money is just EVERYWHERE. And a lot of people have done it, too: some 12-14 million Americans sounds reasonable, many of them Baby Boomers. What they don't realize is that when they turn the retirement age, the IRS demands them to withdraw a certain amount of money from the IRA each year, or be penalized 50% of what they were supposed to withdraw.
Put that into perspective: if the IRS says you have to withdraw $50,000 by April 15 of that year, and you withdraw $40,000 the IRS will fine you $25,000 on top of it, and you just lose out. Pretty scary. So, a lot of advisors are just telling people to do something like a diversified withdrawal: take a little money from ALL of your stocks, that way you don't hurt any one area of your portfolio, and you still stay nice and balanced, while withdrawing the IRS mandated amount.
How well, do you suppose, will this work out when the 1st generation of Baby Boomers start to retire in the next 5-6 years? When the generation that is estimated to have somewhere on the order of $3 TRILLION locked up in the market through diversified portfolios and mutual funds? And they start withdrawing their money in big chunks from EVERYWHERE, all at ONCE?

Diversification just might beggar them. It's not something I'd rather happen, and so will stay educated, informed, and happily focused in my portfolio.

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