by T.J. Wolfe

Created on: April 14, 2009   Last Updated: April 15, 2009

Any investing theory was created in some type of market and pertains to the market that created it. An investment concept is rarely applicable to different markets. Diversification was a concept created during an extended period of rising markets. Diversification capitalized on the strengths of long term growth and stable markets. Long term growth and stable markets supported investing broadly in an index to reduce risk. The index was going up. The investor was guaranteed to match the index.

There is a difference. Today, the stock market is falling. If you follow any type of wave theory, the market has been falling for the last 8 years. It is inadvisable to use diversification in a falling or contracting stock market with high volatility. In fact, diversification would increase risk.

Diversification was a brilliant way of ensuring gains in a rising, stable market. Diversification enables the investor to match a benchmark index like the S&P 500 index and requires little stock knowledge. The investor buys a broad base of equities in the index. The broad base ensures returns similar to the index.

In the last six months most indices have posted losses of more than 50%. The investor who uses diversification is trying to lose 50% or more of their money. Most investors want to gain money in their investments.

The concept of investing broadly presents more problems. In order to match an index, the investor must invest broadly into the index. Investing broadly reduces the need to research and pick stocks. The number of stocks purchased would greatly exceed 20-30 stocks. Most investors have enough money to invest in three to ten stocks. They do not have the ability to diversify into an index.

When an investor can not diversify into an index, they need to know a lot about the index stocks. They also need to be able to compare stocks. Investors make sound stock picks through knowledge. The average investor does not have time to research and compare all the stocks in an index. This makes them an uninformed investor.

The stock market loves the uninformed. Every day, traders take money off the table from uninformed investors. An investor who believes they are executing a diversification strategy when they don't have enough money is a prime candidate to lose money to experienced traders.

In a falling market, the risk of losing money through diversification is guaranteed. The investor is guaranteed to match the index. Since the index is falling, so is your portfolio.

Diversification

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