Diversification is a way to reduce risk, but it cannot eliminate risk. There are investors like Buffett who prefer to concentrate their investments into a few stocks so as to get outsized returns.
Although it sounds attractive, the truth is that most mortals aren’t Buffett and a concentrated portfolio is very unforgiving when you are wrong. Hence, it is more prudent for most investors to achieve some degree of diversification.
The first type of diversification that comes to mind is to spread your capital in a number of stocks.
Assuming investor A has 5 stocks while investor B has 20 stocks, and they equally weight their stocks in their respective portfolios. One of the stocks they both had was a fraud and it went to zero, investor A would suffer a 20% loss while B would only see a 5% damage. This is benefit for the first kind of diversification.
The second is on sector diversification. The danger of concentrating in one sector is that you may suffer drawdown when that sector is out of favour. This is because the market experiences sector rotation once in a while and it is hard to predict which sector will be in vogue.
A recent example would be the tech stocks going out of favour while the commodity sector is breaking new highs. A pure tech portfolio would see drawdowns while a portfolio with both of these sectors in it would see smoother returns.
The third is geographical diversification. That means investing in different countries. Most investors have home bias and tend to invest primarily in their own country securities. US is fine because her enterprises are all over the world but Singapore on the other hand, is a small market. And it is even more important in economically unstable countries such as Venezuela. It makes sense for them to diversify abroad.
The fourth is asset class diversification, that is to not just invest in stocks but in bonds, real estate etc. This is less of a concern because I don’t think anyone will put all their wealth in stocks. One would have a myriad assets in his net worth more often than not.
This is useful when the stock market crashes, whereby security, sector and geographical diversification may not help you. Only asset diversification can. Bond prices may go up or at least your cash retains its value so that you are able to buy more stocks at rock bottom prices.
The fifth is time diversification a.k.a. dollar cost averaging. The advantage of this is that you don’t need to worry about whether the stocks are expensive or cheap. You just diligently buy them. Sometimes you bought them high and sometimes low, but over a long time the prices will even out.
The last is strategy diversification. This is the least practised as most investors have a preferred style of investing. The thing is that besides sector rotation, strategies have their ups and downs too. Value, growth and momentum outperform at different times. The flip side is that a strategy will undergo periods of underperformance that can last for years. Again, employing different strategies can help to smooth the returns.
If these sound too much to handle, that’s where a broad-based stock index fund comes in. It has hundreds of stocks in many sectors and even in different countries. You can buy them on a monthly basis too. It just doesn’t take care of the asset class and strategy diversification.
