Why should I care about Diversification?
21 Apr 2017
Diversification in investing is simply not putting all of your funds into one investment. There are many ways to spread your funds out. One of the easiest is to make sure that you have purchased multiple investments from multiple people. Or is it? One of the issues that the average investor must realize, is that to be truly diversified, we need to look at the portfolio as a whole. Not just the sleeve we may happen to manage.
Diversification vs. Duplication
With the rise of passive investing over the last several years, it seems that everyone has released a product that mirrors the “Market” index. An example would be the S&P 500. This is an index of approximately 500 stocks (currently 505) of the largest companies in the U.S. This wouldn’t be a problem if they were all named after the benchmark they mirror. The problem begins when for marketing reasons, names suggesting differentiation are assigned. This could lead to a situation where an investor thinks they are spreading their funds out by owning two investments, but in reality they are simply owning the same investment twice.
This might not be an issue when looking at low cost passive strategies. A bigger issue arises with “closet” indexers. These are active managers who deviate only slightly from their benchmark. In this case, the investor not only getting a similar lineup of investments, but they are paying for unnecessary fees as well. For more on this, see the recent post about the Active vs. Passive Debate.
What Diversification doesn’t do
Diversification is not a strategy used to generate out-sized market returns. In fact, it is quite the opposite. It is the opposite of speculation. Take for example some of the richest individuals in America. What do Bill Gates, Mark Zuckerburg, and Larry Ellison have in common? It isn’t their political leanings. Each of these individuals have accumulated great sums of wealth by being extremely concentrated in one position. Once they accumulated wealth, they have diversified some, but even now if their companies were to go bankrupt, they would have only a fraction of their current net worth. Surely the quickest way to prosperity is to bet big on one position!
What Diversification does do
Even though this worked out extremely favorably for the people in the example, the majority of us aren’t going to invent the next Snapchat. This is where diversification comes in. When used properly diversification is a risk management strategy. It is an acknowledgement that we cannot predict which stock is going to appreciate in value the most dramatically. We are also acknowledging that we cannot predict which stock will drop in value precipitously. The general idea is to own a little bit of everything. When it comes time to redeem our account, we want the number and magnitude of ups to be greater than those of the down.
Diversification is the acknowledgement that we will have positions in our portfolios that may lose money!
If you were to measure Mark Zukerburg’s net worth on a daily basis, you would see a lot of volatility. Since he is concentrated in one position, his net worth moves up and down dramatically with the price of Facebook. This might not be a problem if you have a few billion dollars. For the rest of us we are intending on utilizing the bulk of our hard earned wealth for future income. We want to put a mechanism in place to make sure it is there in the future. While diversification does not guarantee against loss, having multiple positions with fluctuating prices can help to tamp down the overall effect of large swings. If one position is down, it may be offset by the other which is up.
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How to be diversified
The easiest way to be diversified is to make sure that you own multiple asset classes. This from a high level is generally broken down to Stocks, Bonds, Real Estate, Hard Assets among others. Within each of these categories, further diversification can be achieved. Owning different types and sizes of stocks is a good place to start. Having bonds with different companies, qualities, and different maturity dates can help as well. Ensuring that one stock, bond, or commodity such as gold is not making up a large portion of your portfolio is the goal.
This can be measured a number of ways. Most good financial advisers have made the investment in software that will allow them to analyze a portfolio and let you know what is in it. This can be a great first step to knowing if you are truly diversified, or simply owning the same things multiple times. If you have any questions regarding what your portfolio contains, simply set up your Quick Consult today. We will be glad to help you.
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