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Why Is It Important to Diversify Your Investments?

Why Is It Important to Diversify Your Investments?

I don’t think anybody can talk with authority about the rights and wrongs of diversification and risk reduction in the same way I don’t think anybody can talk with authority about the rights and wrongs of lovemaking. Sure, people can give you advice, darn good advice, but how right and wrong the advice is may only be a matter of opinion.

It is the same as how one lover may like his or her teeth lightly licked with the tip of another’s tongue where another may hate it. People may give you advice about diversification and risk reduction that may appear correct, but the chaos theory and Nassim Taleb’s Black Swan theory shows there are no certainties in life.

Chaos Theory And Black Swan Theory

The chaos theory says (amongst other things) that any predictive model, no matter how accurate is rendered inaccurate over time. The Black Swan theory basically says that the incredibly unexpected occurs more often than we care to admit.

Why Is Diversification Harmful?

In my opinion, keeping all your eggs in one basket is foolish and often motivated by greed. I am not advocating something other than diversification, but there are downsides to it.

The benefits of diversification will quickly diminish if you add more than 30 holdings. This is because when the market falls, then investors lose money no matter what. You can diversify that cancels out the effects of a market decline, but that leads to an aggravation of the second reason why diversification is harmful.

The second reason why diversification is harmful is because it only guarantees an average portfolio performance. If you have balanced your investments to guard against a market decline, then it also suggests that when the market is rising, then at least half of your investments will lose money.

The third reason why diversification may be harmful is because you need truly superior assets to add value to your portfolio, and truly superior assets are hard to find.

What Other Options Do You Have?

Instead of diversifying, you put all of your eggs in one basket. There are plenty of blue-chip companies that will earn you money if you leave your money in there long enough, and the risk is rather small.

You could put all of your money into a single business and work hard at it to make it successful. You could put all of your money into a profitable property, make money from it, and then sell it for a profit when you retire. You could even invest your money into improving your working income and build wealth through saving alone.

These are all alternatives to diversification, and they all have their own risks. My point is that it is more difficult to lower your risk using these methods than it is to invest in numerous assets and diversify to lower your risk of an absolute loss.

Stocks, Bonds, Cash, Mutual Funds, Businesses And Property

They are your diversification options. If you are spreading your money around different assets, then ensure you know enough about each industry/sector and asset investment before you put your money into it. I am only saying that because piling money into different strategies and funds and then calling it diversification is like throwing random vegetables into a pot and calling it a casserole.

Diversification only works if you understand how each investment fits together, and usually it doesn’t take a great deal of research for a broad understanding. For example, if there is a depression and there is less money in people’s pockets, then secondhand stores and repo stores will do well, while jewelry stores and travel agents will suffer.

Another example is if oil prices shoot up quickly. The retail and logistics industries are usually the first that are hit negatively. Shares in renewable energy companies often start to rise during these times as people start thinking of the future and how they may free themselves from the stranglehold the gas companies have on them.

With these two crude examples, you may see the benefits of diversifying with investments in secondhand stores and jewelry stores, and stocks in the logistics sector and renewable energy industry.

How Much Time Do You Have?

Time should affect how you diversify. If you are investing to build enough money for a college fund, then you may have less time. You may also be less willing to take big risks. This may pose a problem, since your time limit is relatively short and yet larger gains over a shorter time are often the result of riskier investments. Plus, you may need assets that you can dissolve within the space of 12 months.

What Is Your Risk Tolerance?

How you diversify may depend on just how much risk you are willing to take. Too few holdings may offer bigger rewards, but offer less protection. On the other hand, if you diversify too much, there is a good chance you will see very little profit and may even see an unavoidable loss.

What Is Your Risk vs. Reward?

When diversifying, you should be thinking about what you are going on lose more than what you are going to gain. In my opinion, diversification is more about lowering risk than it is guaranteeing a reward. A portfolio that is not wiped out is a plus, and one that gains a modest amount of value is a win (at least when it comes to diversification).

Diversify Between Asset Categories And Within Asset Categories

This should be common sense, but it is tricky. After all, my previous advice was to invest in what you know and understand, but diversifying within an asset category often means venturing into areas you do not understand. For example, if you were investing in property, you may fully understand the buy-to-rent industry, but buying a hotel, office blocks, or pastureland may be completely new to you and something you do not understand.

The Downside of Diversification: You Need More Money

Diversifying costs a lot of money. If you diversify by investing smaller amounts, then you are less likely to see a return and may even see a loss. You need a fair amount of money before you are able to diversify in a profitable way. For example, if you are diversifying amongst stock sectors, then you are going to need at least $10,000 so that you may invest while remaining profitable. If you are investing in property, then you will need much much more. The largest sectors in the market would need at least $1000 each to give you minimum exposure to each.

About The Author

Ben Todd

Ben was a seriously broke graduate student with bad credit who after finding himself rejected for any sort of credit card or loan for most of his adult life, finally decided to get his financial life in order. 'He spent several years reading as many financial advice books and blogs as he could.And suprisingly, Ben found he actually LIKED the topic of personal finance; after fixing his own finances, starting his own successful work at home website business, and using his earnings to get out of debt, created echeck.org to help others do likewise!

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