Do Not Diversify For The Sake Of Diversification
Many new investors, which I consider myself to be, have been poisoned by the diversify-or-die mentality. I'm not sure who started this crap, but my incriminatory finger is itching to point towards the mutual fund managers.
Here's my theory about mutual fund manages... Mutual fund managers have a job to do — beat the market return. However, beating the market return is not an easy task. Not many fund managers can beat the market. There are only a handful who managed the feat, and I'd go as far as saying these guys are amazing. The rest failed because they just didn't really care. They just kept buying and buying every company they could find. In the end, they own more if not as many stocks as the S & P 500. When asked why they bought so many stocks, their answer is always a simple "diversification". And the novice investors breath a sign of relief thinking it's safer for their portfolio.
Deworsification
Peter Lynch referred to diversification that resulted in a poor return as "deworsification". When he wrote this, he was referring to companies that were not making the best use of their cash.
However, this very same principle applies to how we as investors allocate our investments as well. Many of us are used to the idea that diversification mitigates the risk of losing everything in your portfolio. Diversification is often linked to the don't-put-all-your-eggs-in-one-basket premonition. Unfortunately, this is far from the truth when it comes to investing.
In my previous article, I listed two factors that determined risk. When you invest in something you don't know, this is likened to gambling. Gambling is clearly high risk. When you bet all your money on a stock because Barney Gumble said it's the next big thing, you're clearly thinking you're placing all your eggs into a basket when really it's a blender.
On the other hand, if you knew that you're putting your eggs into a basket that is bulletproof, fireproof, waterproof, hurricaneproof, theftproof and everything-else-proof, why in the world would you not put all your money into this super-basket? Nonetheless, there's no certainty in investing. Nobody knows whether a basket is everything-proof. Consequently, diversification is a necessary evil to a certain extent.
When Diversification Becomes Deworsification
Diversification is like drugs. Too much of it, you'd overdose.
Let's take a closer look at how diversification makes it harder to beat the market. Comparing the Russell 2000 Index with the S & P 500 Index, we have the chart below:
As you can see, the S & P 500 outperformed the Russell 2000 almost every year. Could this be because the Russell 2000 is more diversified than S & P 500?
So Should You Diversify?
Unfortunately, I'm not sure what the right answer is for you. My strategy is simple. I do not care about diversification. I try to buy the best stock available at a time. If I purchased every good stock at a bargain, it doesn't matter if all the stocks in my portfolio is in the insurance industry because the stocks will grow regardless.
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I heartily disagree. Fatboy begins by acknowledging that he's a newbie to investing and then he goes on to share his "wisdom" with us. Do yourself a favor and steer clear.
He said, "When you invest in something you don't know, this is likened to gambling."
I would add: "When you blog things you don't know about, this is likened to rambling."
Instead of Fatboy: read Malkiel, Bogle or Ellis. There's a great deal of good stuff in academic finance about proper diversification. No, the S&P500 is NOT diversified. It's all large growth. The Russell2000 is not diversified, it's all small market. But if you had something like a blend of small market, large value, short bonds, REIT's, emerging markets & EAFE. Then you would be more diversified.
Do yourself a favor and read Malkiel or Bernstein or Swedroe or Armstrong. Those guys can teach you about risk-adjusted returns, modern portfolio theory and the benefits of proper diversification.
I usually read pfblog for responsible insights to personal finance. But this post is a disaster.
It is kinda ironic in that in the end of your graph the more diversified russell actually out performed the sp500. If you had just kept your money through it all.
But you are partially right about diversification, statistically you only need about 6 stocks to hit the sweet spot in diversification, but what is important is the covariance(how stocks move together) of the stocks you have.
Since there is no simple or easy way to measure covariance of a portfolio, some guidelines should be to have stocks with diffrent beta's (beta represents how stocks move with the market, high betas of over 1 and mean that if the market falls 10% that stock would have fallen more then 10%, a beta of less then 1 means that if the market fell 10% the stock fell less then 10% but would have still fell. Beta's of 0 mean that the stock has no noticeable relationship with regards to the market, and negative beta's mean that if the market falls the stock usually goes up.)
So for an amateur investor try having a broad range of beta's, and diffrent industries that way you should be diversified enough with out getting in over your head.
You ideas on diversification are incorrect. Put simply, you are only discussing returns, and you are ignoring risk. For a given return, diversifying across asset classes will lower your risk.
Using that chart to draw conclusion about diversification is hilarious. That chart doesn't tell you that Russell 2000 performs better than S&P 500. In fact, over 10 years, they are both up by about the same: 120%.
Diversification is not just about return. The reason you diversify is to reduce risk.
