Going deep with diversification
Going deep with diversification

The principle of solid investment diversification is one of the fundamentals of money management. It isn’t complicated, either – investors reduce their risk by spreading their assets across a range of markets and exposures.

But what about the complexities of diversification? For instance, Warren Buffett, hailed as one of the world’s greatest investors, has been quoted as saying that “wide diversification is only required when investors don’t understand what they are doing”.

Is diversification really only for beginners, then?

Yes, and no. There is such a thing as over diversifying your portfolio. Diversification is an art, a process that should be changed and fluctuate as an investors becomes older and wiser about financial markets.

There are some key principles we should follow when considering diversification.

You can never diversify enough to eliminate risk

It’s important to realise that while diversification is important, you will never be able to diversify risk out of your investments entirely. Just as we describe elsewhere in this newsletter, risk is always present – managing it is the real question.

You can hit a plateau of diversification

Modern portfolio theory teaches us many things. One of the most important is that when stocks are added to a portfolio, standard deviation, (risk), decreases. But risk decreases at a very low amount once the number of stocks in a portfolio reaches 20. Beyond that, adding more stocks doesn’t increase diversification much at all.

Of course, this depends on the type of stocks in a portfolio. But it illustrates a key point – simply adding stocks to diversify your portfolio doesn’t necessarily work after a certain point.

Understanding true diversification

Many investors may begin their financial journeys thinking diversification is as simple as “owning a large number of assets in different contexts”. This is untrue. Diversification – true diversification – requires choosing and picking investments from a variety of areas in order to truly balance your portfolio.

For instance, while owning 20 different stocks may diversify your holdings, investors must know whether these investments are in different industries or markets. (And even then, must realise those same stocks – if on the same index, such as the ASX200 – are all subject to the same volatility).

True diversification means understanding where your investments are located, and separating them so adverse market conditions in one area does not necessarily affect all of your portfolio.

Constant re-tooling

While many investors would opt for a “set and forget strategy”, which can have its advantages, true diversification means assessing your investments regularly. The old adage of “selling high and buying low” matters.

This doesn’t need to be a constant process. For many investors simply examining their portfolio every year is enough to adjust themselves to any market fluctuations.

But this strategy is crucial, as it emphasis a key point – diversification is an ongoing process, not something that simply happens during the initial purchasing of stocks.

It’s possible to hurt returns through diversification

This brings us back to Buffett.

If “wide” diversification is only necessary for investors who don’t know what they’re doing, does that mean experienced investors don’t need to diversify at all?

Hardly. It simply means for the experienced investor, managing the risk that comes with multiple investments becomes easier. Remember – it is easy to over diversify. Owning a wide variety of stocks and assets in a range of markets can impact the ability of your “big earners” to deliver returns above the market. (Just as diversifying lowers the risk of market volatility, it also opens you up to the opposite – exposure to poorer performing markets dragging on your top performers.)

Do you have questions about diversifying your portfolio? Get in touch with someone at Maddern – we’d love to answer any queries you have.

Disclaimer: The information on this site is of a general nature only. This is not a recommendation or endorsement of any product or investment. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions or consult the advice of an accountant or financial adviser.

Back to insights