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.
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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:
- Sleep deeply and peacefully at night
- Tend to other pursuits without concern for his investments
- Not worry about the direction of the financial markets
- Not have to monitor his investments continually
- Go through painful (and expensive) learning curves
- 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?