If you know anything about investing, you’ve probably heard over and over again that diversification is the way to go. Most financial advisors will tell you that diversification is important because it protects you from risk and market volatility.
The basic idea is that by diversifying, you’re putting your money into different types of assets. If one tanks, your others are still protected. There is always risk in any major market and that’s unavoidable; but by spreading your money out, you’re keeping yourself covered.
In theory, diversification is good, but it’s not quite that simple. Consider Warren Buffet’s definition: “Diversification is protection from ignorance.”
What he means is that most people diversify to protect themselves from risk but they have no idea how it does that; just diversify and forget about it. In other words, it gives them a false sense of security about where their money is invested.
The truth is that you need to examine your diversification more closely. First of all, there are different types of diversification (we’ll get into that next time). Second, diversification isn’t inherently “good”; there are some disadvantages that you should be aware of.
For one thing, diversifying means that you won’t see really large returns. After all, the golden rule of investing in stocks is that bigger risk gets you bigger reward. Usually, your return is a weighted average of all of your different stocks. Diversifying gets you growth that’s slow and steady, but you won’t see major sudden gains. Then again, you won’t get wiped out when a company you’ve invested in goes belly up.
Some investors fall into the trap of becoming investment collectors. If diversification is a good strategy, why not diversify as much as possible? They over-diversify their portfolios and then find themselves paying a lot more in transaction fees and taxes.
There’s also a chance that your diversification won’t protect you from risk at all. When there’s a global financial disaster like the one we saw in 2008, diversification wasn’t any help to investors. Everybody suffered no matter where they put their money because, even though it might have been spread across different sectors, it was still invested in paper money.
There’s also the common misconception that “diversifying” simply means investing in stocks from different sectors, but this is just one type of diversification. We’ll get into that in the next email message, but for now, remember that it’s not as simple as saying “Diversifying is good.” There’s much more to it than meets the eye.