Why Investment Diversification Doesn’t Always Work

Diversification. We hear that word a lot when it comes to investing; it’s almost an article of investment faith. On paper, diversification always works, and in the right hands, it can work fabulously. But is it right for everyone? I’m going to step out of the box of conventional investment thinking and say that diversification isn’t right for everyone, and here are the reasons why.

3 Reasons Why Diversification Fails

Diversification’s Achilles Heel

Though it sounds counter-intuitive, the primary problem with diversification is that people usually diversify into investments that they don’t understand.

They don’t need to be told to invest in what they DO understand — it’s a natural move. They understand certificates of deposit or real estate, but they go into stocks and bonds because they’re told that they need “proper diversification”. Because they don’t understand what they’re diversifying into, disaster is often the outcome.

Diversification is only an effective strategy if you understand the investments you’re adding to your portfolio. If you don’t it can be a recipe for big losses.

Diversification Can be the Investment Path to Mass Confusion

In today’s complex financial world, we’re told to attain prosperity through many investment channels — stocks, bonds, real estate, mutual funds, ETF’s, certificates of deposit. Then there are the “cookie jar” accounts — Christmas clubs, emergency funds, college education funds — you name it. The textbook investor has his or her money spread out all over the place. There’s an account for every possible need, and a pattern of diversification within each.

But is this the path to prosperity — or mass confusion? If finance and investing is your “thing” there may be no trouble keeping it all balanced — you may even enjoy doing it. However, for the average investor, who most likely has a day job, it can seem like stepping into the preverbal hornets nest.

When you’re confused, you’re judgment is clouded; when your judgment is clouded you can make mistakes you wouldn’t otherwise make.

Timing is Everything

Often when a person decides to diversify into the stock market they do so at or near the top of the market. Perhaps it’s just human nature, but the most timid of investors tend to get into the market just as it’s about to take a tumble. This is part of the reason stocks enter mania phases — ordinary people who might not be in the market otherwise take the plunge sensing that it must be safe because it’s run so high for so long.

The same is true of bonds; many investors get into them when interest rates are at or near their lows, hoping to lock in higher rates than they can get on shorter term securities. When interest rates begin to rise, the price of the bonds begin to fall and the novice bond investor is being attacked on both sides. He’s now locked into a low rate of return on a bond that’s falling in value.

Similar cases can also be made for diversifying into commodities and real estate at the wrong time.

Unfortunately, when you’re looking to diversify, and you don’t fully understand what it is you’re diversifying into, you’re particularly vulnerable to timing errors. And if you take a big loss early in the game, you’ll most like sell out of the losing investment — thus locking in your loss — and never return again.

Success in Simplicity

Part of the advantage of the not diversifying is in its simplicity. The saver picks one or two investment classes that he understands and has worked with for a long time, then loads them up with the conviction of a squirrel gathering and storing nuts for a long, nasty winter. There’s no in-and-out maneuvering, no timing schemes, no rebalancing, no tax angles and no chasing yield.

The investment of choice could be certificates of deposit, money market funds — or even passbook savings. The investor has his money only in what he understands, which frees him to:

  1. Sleep deeply and peacefully at night
  2. Tend to other pursuits without concern for his investments
  3. Not worry about the direction of the financial markets
  4. Not have to monitor his investments continually
  5. Go through painful (and expensive) learning curves
  6. Not take big losses when markets fall—he makes money, in part, by not losing any

When it comes to diversification, we can’t assume it’s the right course for everyone. It may be an excellent strategy for someone who is heavily invested in risk investments, like stocks, real estate or commodities, and needs to reduce risk. But for more conservative investors and savers it could be an attempt to persuade them to take on risk they aren’t comfortable with.

I’m not saying diversification is a bad thing, only that it isn’t right for everyone. Agree or disagree?

About the Author

By , on Jun 7, 2012
Kevin Mercadante
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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Leave Your Comment (12 Comments)

  1. Alan@escapingmydebt says:

    it also helps to understand the correlation between stocks and other investments. If you think you are diversifying by obtaining a few different stocks, do they tend to move in the same direction due to certain events. Also understanding systematic and unsystematic risks will help out.

  2. Jonathan says:

    I think you should go into more detail if you are going to talk about different asset classes or portfolio management in general. Every asset class is subject to risk. Speaking of “risks” without identifying or quantifying them is only telling half the story and half the truth.

    Sure, bonds go down as interest rates rise, the saying is a bit of a cliche actually. Yet the price movements bond holders are beholden to in volatile interest rate environments are subject to a bonds duration, maturity, convexity and its position on the term structure of interest rates. In other words with one bond you could care less what rates do while another you would get slaughtered.

    You saying that one could sleep easy at night by investing in CDs, money market funds or passbook savings accounts (which are technically all the same asset class BTW)is misleading. Inflation will destroy any future purchasing power, yet you allude to deflation which has NEVER happened for prolonged periods of time since the inception of the federal reserve. QE infinity will see to that.

    Not to mention, when Lehman broke the buck in `08 numerous individuals who held money in money market accounts LOST around 70% of the value of their money market holdings. It took over a year to even receive a redemption. Crazy, frozen money in a money market account! Yet money market accounts are typically spouted as being “risk free”.

    Risk has to be quantified! Blanket, generic statements regarding “risk” hurt novice investors, life is full of opportunity costs and the risk of leaving your money in cash to sleep easy at night is the risk of having $100,000 when gas is $20/gallon.

    In an environment where ALL asset correlations are nearing one, the markets are exceptionally volatile and banks would go bankrupt overnight if they had to market to market off balance sheet derivatives, risking return of capital, for return on capital! Counter-party risk will ruin you. Still, few people address this risk.

    Fundamental analysis and financial statement analysis no longer work in a market where 80% of the volume comes from robots. Still, few people address deteriorating corporate balance sheets in a rising market, soaring solely due to QE one, through infinity and beyond and high frequency bots chasing BETA and scalping your grandma.

    US government securities are at all time highs, flight to safety right? Uncle Sam has never defaulted so it will never happen right? What about fat tail risk, events with probabilities so low people fail to address them, yet if they do happen destroy holders of US bonds. The world doesn’t exist on a probability distribution curve that is perfectly symmetrical, a curve that most value-at-risk models are based on, and frighteningly so. Still, even fewer address the systematic risks created by such models.

    Sovereign default risk, municipal bond default risk, currency risk, US deficit risks, dollar devaluation risk, inflationary policy risk and many others all usually poorly addressed or done so in a glaringly generic manner, i.e. skirting inflationary risks by mentioning deflation which, historically speaking, only happens for an extremely short period of time, after prolonged periods of inflationary policy and creates a situation where one bubble (real estate) was papered over with the unintended consequence of creating another (dot.com). What are the unintended consequences and risks of QE infinity? Most definitely not the intended consequence of economic recovery.

    Today’s investing environment is so manipulated by interventionist policies (another poorly addressed risk) that the increasingly generic advise that is given to new investors seeking expertise will only end up destroying them in the end.

    Gone are the days that one could simply “diversify” and sleep easy, or go cash and sleep tight.

  3. Hi Jason–How does a person who’s risk adverse reduce risk by taking on more risk? Not everyone has the emotional make up to do that, and that’s perfectly fine.

    Hi Andy–Diversification has a way of evening out the ups and downs, not doubt about it. But some people are ready to jump into the lifeboats the minute an investment drops in value. So for some, diversification gives them peace about there investments, for others peace comes from having investments that don’t fall in value. It is very much an emotional dynamic.

    Hi Jonathan–EXACTLY! And some people can’t handle losses. Emotional factors and knowledge levels can never be divorced from investing. You have to know yourself before you get into investing.

  4. Jonathan says:

    Excellent article. The whole point of diversification is to spread risk, but there’s no logic in doing this if you diversify into something that you have no knowledge of, because you are just as likely to incur losses.

  5. Andy says:

    right… at many times i don’t even bother much about fluctuations in the stock,
    may be i am not too serious about investments i have made as others might be…
    but i can also blame the diversification for this loose interest..

  6. Jason says:

    I completely disagree with this article. The article assumes that the simple investor who does not know anything about the stock market, bonds, etc. would be in a world of hurt if they tried to LEARN about these investment classes and diversify. Or better yet, if they were to give their money to a brokerage firm or financial advisor who would diversify for them. Granted that would be the expensive way to go but at least they’d still be reducing risk. It’s not complicated, you can google “assett allocation” and find simple ratio’s of how much of your money should be in each class. I can’t imagine anyone who accumulates a significant amount of wealth/retirement being too naive to be able to figure out simple diversification.

    I would encourage a 65 yr old who knows nothing about to stock market to put 20% of his retirement in large cap ETFs. Would you have that person keep it all in bonds or CDs??

    Diversification is a gimme, no-brainer technique that should be applied to ALL retirement accounts. Period.

  7. I absolutely agree with diversifying within an investment class. You could always do that with CD laddering, mutual funds, etc. The point I was making was diversifying by getting into investment classes you don’t understand.

  8. Josh says:

    I didn’t say everyone needed to invest in stocks, I said everyone should diversify, there is a large difference. Diversification does not mean stocks have to be involved. A diversified bond portfolio means you don’t just own one companies bond so if one company goes bankrupt you don’t lose anything. A diversified CD portfolio means having different maturity dates and banks so that if rates increase you have some cds coming due and if a bank goes out of business you don’t have all your cds in one bank. You can certainly get rich by not diversifying, Bill Gates and many others have, but you can also become very poor.

    The whole point of diversification is to reduce risk. You likely won’t make as much and you won’t lose as much, but that is the whole point. Diversification is a neccessary aspect of investing, unless your fine with bankruptcy being your biggest downside.

    Diversification is right for all, there’s a reason Trump has gone bankrupt multipe times and anyone reading your blog probably has a lot more on the line.

  9. Josh, you and I just have different points of view, it doesn’t mean either of us are wrong. For example, I think it’s wrong to tell a 65 year old who’s never invested in the stock market that she needs to diversify into stocks. Also, your advice on stocks talks about inflation–what if we got into a deflationary environment? Fixed income would be the way to go.

    In general, I’m with you on diversification being the better way, but we can’t paint with a broad brush and say everyone needs to do it.

    I’ve worked in businesses where I’ve had a chance to see that many people who diversify never accumulate much money, and other who put all their money into savings accounts and have fortunes! Diversification is just on aspect of investing, but it’s hardly the holy grail.

    Right for most, sure–no argument there. Right for all–absolutely not.

  10. Josh says:

    Investors are generally not risk averse, they are loss averse. When it comes to a real world scenario, people are concerned about being able to continue living their target lifestyle and money is a means to that end. The bumpy ride along the way may be a concern but if you tell someone they can either put up with a few bumps or be guaranteed to fail, they will put up with a few bumps. The balancing act is whether they want to “eat less well, or sleep less well” but for anyone reading your blog there will be a balancing act.

    This doesn’t mean that they neccessarily have to be in stocks or risky investments, but the worst thing they can do is fail to diversify. Telling people to pick one or two classes they really understand leads to the potential of inflation eating away at the cash value of a cd portfolio to the point that an all cd portfolio would have to be about $1,056,000 to support a $30,000 yearly lifestyle for 30 years of retirement, or it leads to the potential for someone loading up on real estate in 2006.

    This blog would provide a much better service by educating people how to diversify rather than discourage it so people can be comfortable right up until the moment they realize they are headed for certain failure and it is too late to do anything about it.

    As investors we are not going to know more than the professionals to be able to compete with them. Not starting to invest until you “know” something just means you either never get started or you have way too much confidence in your knowledge when you begin and you fail to diversify because you are blinded by ego. Mutual funds, ETF’s, Annuities, CD’s, and Money Markets all exist so you don’t have to pit your understanding against that of the professionals. Teach people how to use them, don’t give them false comfort by telling them it’s ok to avoid them.

    Real people read your blog and if they take comfort in bad advice and follow it then you are ultimately responsible, remember that.

  11. Hi Josh–I’m not saying diversification is a bad strategy or even that is isn’t the better way for most people. What I am saying is that it may not be the right strategy if it causes people with a conservative investment preference to diversify into higher risk investments that they don’t really understand.

    We used to hear the term “widows and orphans” investments, but that’s kind of died out. Now we’re told by the financial media that you need to be in stocks all the time. Logic tells us that isn’t right for everyone. A lot of people have no tolerance for risk, and that’s perfectly alright.

  12. Josh says:

    You’re on notice, keep publishing this uneducated rubish and I’ll unsubscribe. This is not educational, it’s damaging to those who don’t know and came here to learn. Filter what you post because people are depending on you for education.

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