September 30, 2022
When my daughter was about 7 years old, she would dress in a style that we kindly called “eclectic.” Her fashion strategy at the time was mixing as many styles as she could find in her closet. The result was a mishmash of clothes – floral patterns mixed with plaids, mixed with paisley, mixed with stripes and polka dots – and a lot of cringe-worthy pictures that the (now) 17-year-old would like to forget.
Investors who aren’t careful can fall into a similar style. When diversification goes too far with a portfolio, it can move into what is called “diworsification.” Simply put, diworsification is when retail shareholders spread their investments over too many highly correlated asset types – the act of over diversifying their portfolios to the point where they negatively impact risk and return.
It is a relatively easy trap to fall into, even for the careful retail investor. After all, most investors believe that diversification is good (and it is). Problems occur when, in an effort to diversify, investors buy a group of assets that might seem different, but are actually highly correlated and act almost the same, even though the companies might operate in radically different sectors.
True diversity isn’t just owning different stocks in different areas of the economy, though that’s a start. True diversity in investing is owning assets that do not move in sync with one another. As some stocks move higher in your portfolio, it is natural that others might dip. That is a sign of a diverse portfolio.
Just because you have what you believe to be a diverse portfolio with a dozen growth stocks, you can still fall into the diworsification trap. Even though those growth stocks come from a variety of sectors, they often still move in tandem, which doesn’t reduce volatility, which is the real benefit of diversification.
Warren Buffett said, “Wide diversification is only required when investors do not understand what they are doing.”
He is certainly right. Simply adding additional investments to your portfolio will not prevent diworsification. There is a point where the cost of adding another asset to your portfolio can eclipse its marginal benefit – a point where you are over-diversified. Quantity does not necessarily equate to diversification.
It might be difficult to balance diversification, especially when some experts believe a diversified portfolio includes between 10 and 30 different companies while others recommend owning more than 300 different stocks. Who’s correct? Again, it depends on the portfolio. Trying to hit numerical targets is not necessarily going to create a diverse portfolio, regardless of the number of different assets held. Investing in ETFs can help, but investors can fall into diworsification there as well if the ETFs move in a similar way.
To be truly diversified, retail investors could consider a portfolio that is invested in assets across different industry groups.
Another way would be to follow the advice of author Peter Lynch, who wrote in “One Up On Wall Street” that stocks should be classified by type, such as stalwart, turnaround, hidden asset, fast-grower, and slow-grower and investors should have assets that reflect a blend of those types, regardless of sector.
Portfolio diversity can come in several ways, including investing in different industries, different sized companies, and different performance expectations (such as value, growth, blend).
Diversity can help you earn extra perks from TiiCKER. Retail investors can earn valuable perks simply for owning shares of companies they love. The more shares individual investors own, the more they can take advantage of the valuable shareholder rewards found on TiiCKER.
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