Diversify Portfolio, or Not

”Don’t put all your eggs into one basket,“ we always hear. The purpose of diversifying our investment portfolio is to protect our wealth by reducing the exposure to risk and volatility.

By investing in different asset classes that have low correlation with one another, portfolio risk is reduced. Stocks, bonds, real estate and others are unlikely to move together in the same direction.

However, should we diversify within the same asset class? The answer is it depends.

Take the stock market for example. Some stocks perform better than the market average. And some perform worse than the market average. By investing directly in company stocks, you are exposed to this huge volatility. Your portfolio stock performance is tied to a single stock performance, which is also tied to the performance of the underlying company and its management team.

One way to diversify in the stock market is to invest in funds such as index fund, growth fund, income fund among others. These funds invest in many companies and any changes in the values of these companies will affect the value of the fund. This reduces your portfolio risk because now your risk is spread among many companies.

Diversification and investing in funds have been championed mostly by fund managers. They tap into our fear of risk and the fear of being different. In general, people are content with their investment if their portfolio performance is close to the market average.

By investing in funds you also reduce the need to keep track of your portfolio because the fund manager is tasked with monitoring the performance for you.

However, if you intend to have a portfolio that outperforms the market consistently over the long term, then you will need to stray away from the herd.

Investment greats such as Warren Buffet have refrained from diversification. They felt that it was a mistake to teach investors that putting their eggs in many baskets reduces risks. The danger in purchasing too many stocks is that it becomes impossible to watch all the eggs in all the baskets.

These investors believe that it is better to focus only on a handful of stocks. This will allow adequate time to research, understand and keep up with the changing environment in which these companies operate in.

Thorough research will filter out underperforming companies. You are then left with the star performers. Using a sound valuation approach to value the company or stocks based on facts will reduce the chances of you overpaying for the stocks.

These investors reason that with proper methodology, research and valuation approach, risks can be greatly reduced. The idea of reducing portfolio risk through diversification is not necessary.

In the end, to diversify or not depends on the individual. Not all investors are born the same. The factors influencing diversification or not include your business, economics and financial and industry specific knowledge. It also depends on the amount of time and the level of commitment you are willing to put to manage your portfolio.

Diversification reduces both the upside and downside potential of a portfolio. However, it allows for more consistent performance under a wide range of economic conditions.