A common lesson from a children’s story book has become one of the guiding principles for investing: “Don’t put all your eggs in one basket.” But lately, I’ve come across a few articles where people are questioning the wisdom of diversification. Today, we are going to ask the question – could you make more money investing if you did not diversify?
But, first here’s a quick definition of diversification: “to spread out your investments amongst different types of funds”.
Photo via Wikimedia Commons
The Theoretical Answer
Theoretically, you can make more money (investing or otherwise) if you do not diversify. Let’s say, for example, there are three mutual funds.
- Fund #1 increases 15% over the year.
- Fund #2 increases 20% over the year.
- Fund #3 increases 10% over the year.
Theoretically, you would make more money IF all of your money was in fund number #2 instead of a third in each fund. Having a third in each fund would only yield a 15% return, while fund #2 yielded a 20% return.
Diversification and Risk
So, why should you diversify your investment portfolio? But that’s a big IF, and in real life, we also have to deal with WHEN.
One thing every new investor must know is that risk and reward have an inseparable relationship. You cannot get one without the other. In other words, if you want to increase your return, you must be willing to increase your risk. Conversely, if you want less risk, you will need to sacrifice your potential for gains.
I believe this one investing lesson could save investors millions of dollars annually. Those who seek to get rich quick by investing in something with unrealistic gains usually end up losing everything.
Two Reasons Why You Should Diversify Your Investments
The long term results are better
The turtle still wins. Anyone who makes a big killing off a single stock will rarely walk away unscathed. They will often reenter the market with another gamble and eventually the risk will catch up.
Take the slow, steady, and diversified approach. It is better to slowly get to a million dollars than risk everything to get to ten million.
Not being diversified can be emotionally wearing. When you are diversified, there is probably something going up when everything else is going down. At least there is something holding its ground better than others.
Diversification has a built in ‘plan B’ in case you were wrong.
Sometimes, emotional security is more valuable than financial gain.
The Danger of Going All In: Investing Without Diversification
When I was a kid, I used to love to play the game Stock Ticker (yes, yes, I still love it). In the game, the market is controlled by the roll of the dice. The dice dictate which shares will decrease in value and which will increase in value. If a share drops below the zero line, you lose everything.
The game really doesn’t have an ending, so we usually just say we are going to total up the value of your shares in x # of minutes.
The winner of the game is almost always the person who will sell all of their other shares and buy all the cheapest share. If in those last rounds that share goes up, you have significantly increased your value. If, however, it goes down, you will lose everything.
The person who risks everything in Stock Ticker either finishes first or last.
Going all in on an investment means you risk everything. I’m sure there is someone who has made a lot of money by investing everything in one stock. There are probably thousands of people like that. They went against conventional wisdom and the payoff was huge.
That’s why investors today think they can do it, too.
However, we also need to realize that for every success story, there are 10 people who lost everything by going all in on a stock they just knew was going to succeed.
The risk of investing without diversification is too much.
What do you think…does investment portfolio diversification still work?
Craig Ford is a fulltime missionary in Papua New Guinea who writes Money Help For Christians and Help Me Travel Cheap, a frugal family travel blog. He is the author of Money Wisdom From Proverbs, has a Masters of Divinity degree, and (most importantly) eats homemade pizza with his family every Friday night.