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Why Investment Diversification Doesn’t Always Work

Why Investment Diversification Doesn’t Always Work

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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?

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Josh
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Josh

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.

Josh
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Josh

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… Read more »

Josh
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Josh

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… Read more »

Jason
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Jason

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… Read more »

Andy
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Andy

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..

Jonathan
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Jonathan

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.

Jonathan
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Jonathan

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… Read more »

Alan@escapingmydebt
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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.

Why Investment Diversification Doesn’t Always Work

by Kevin Mercadante time to read: 3 min
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