In investing, diversification is stressed as one of the key elements to a risk-balanced portfolio. It’s true: a certain amount of diversification is critical; otherwise you wouldn’t receive a return for the level of risk you take. Major market surges and month-to-month volatility (measure for variation of price of a financial instrument over time) could bring devastating losses to your portfolio if it has too many eggs in one basket.
But believe it or not, there is such a thing as improper diversification, which can also be very harmful to your investments. For example, diversification can expose a percentage of your portfolio to underperforming sectors of the market.
Following are some other ways diversification can fail to work in your favor, as well as an explanation of proper diversification:
1. Not enough attention to portfolio
Even if someone else is managing your portfolio, make a point to check in from time to time in order to ensure your it’s diversified at level where you’re comfortable. Don’t wait until after your quarterly statement arrives before realizing things are out of balance.
2. Ineffective Investment Funds
It’s possible to over diversify your portfolio by using certain investment vehicles that have a tendency of underperforming against the market over time. Possible examples are index funds or actively traded mutual funds, which can sometimes focus on short-term trading instead of long-term quality and value.
3. Below Average Returns
Below average returns can result from diversification when inferior investments lessen the quality of good investments. Low returns can also be caused from high transaction or mutual fund fees. Make sure your emotions aren’t causing you to buy high and sell low.
4. Too Complicated
If you have too many assets in your portfolio, you’ll end up paying a bundle in transaction fees and may have little to show for it. It’s also important you don’t have so many assets that you don’t understand what’s in them. While diversification is important, you should keep your portfolio simple enough that you can decipher where your money is going and what investments make financial sense.
5. Reduction of quality
The more stocks you put in your portfolio, the more possibility you are investing in lesser quality companies. While you certainly want variety in your investments, you should also be selective in the funds you choose, as well as making sure those companies provide a margin of safety (difference between the intrinsic value of a stock and its market price).
The bottom line: You can avoid the disadvantages of diversification by properly managing your portfolio. When purchasing stocks, choose high quality companies that are properly priced so the odds of a successful return are your favor.
While diversification is one of the most important and effective concepts in investing, it’s important to go about it in the right way. Keep in mind the disadvantages of diversification as you construct your portfolio in order to keep your portfolio in top shape.