The Limits To Diversification

While indeed diversification might reduce the volatility of the investor’s portfolio, there are certain factors that the investor needs to be wary of.

Diversification is one of those investment strategies that we have all learned, re-learned, and over-learned. The reason for it is primarily to reduce portfolio risk in such a way that one asset nets off or curbs the losses of another asset or security.

However, as advantageous as it is, the truth is that it isn’t always great. It too has its limits. In fact, acclaimed investor Warren Buffet believes that experienced investors should rather choose stocks on a long-term basis and have faith on their investments as opposed to trying to carefully balance volatility.

He believes that when opportunities arise for individuals to purchase amazing stocks with great potential, they should be exploited to their full potential and not tiptoed around. At the foundation of diversification is a risk that few stocks might lose so badly that they wreck the investor’s entire portfolio.

While indeed diversification might reduce the volatility of the investor’s portfolio, there are certain factors that the investor needs to be wary of.

Does Not Eliminate Risk

One of the worst things an investor can do is to get comfortable or complacent with his or her portfolio because it has been properly diversified. The truth is that while diversification can actually help reduce the level of risk, it does not eliminate them in any way.

It cannot promise you a profit and it also cannot guarantee that you don’t make losses. This is because what matters are the stocks and not necessarily what measures you take based on them. In essence, if you invest in a bunch of stocks that suck, your portfolio would still lose.

It Can Get Too Complicated

It is easy to say that you need to invest in different kinds of securities that span across a number of industries, and possibly growing at different paces – and indeed this is safer than investing in one type of stock. However, this can become too complex to manage.

Investors might have too many assets in their portfolio that they end up not being able to track or even fully understand what they are made up of. This completely defeats the purpose of diversifying in the first place.

It Reduces The Quality Of A Good Portfolio

Diversification might do a great deal in reducing the losses where a portfolio is going down the wrong path and negatively correlated investments or hedges have been made, but it is also capable of wrecking a good portfolio.

For example, if you have hedged a stock with say three other stocks and that main stock turns out to be the best decision ever, the other three stocks stand in the way of its progress and cut down a huge chunk of your expected returns.

Cost

Investing in one stock will certainly cost a lot less than investing in five stocks. For you to invest in the stock market, you would need to have a broker and brokers all charge commissions or transaction fees based on the amount of stocks invested. While this is not expected to be high, it too can be a deterrent to the amount of gains you make on it.

The key in investing is in first choosing good stocks and having a good understanding of those stocks in relation to your investment goals and your plan. Diversification is generally not a bad idea, but it is important that you have these factors in mind as you hedge against volatility or risk.

Written by Lawretta Egba.