Investments

What Does 100 Portfolio Diversity Mean

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 11 minute read

One of the first things taught to new investors is the importance of spreading their money around. Nearly all guides to successful investing emphasize the importance of spreading your money around.

However, many of the world’s most prominent financiers warn against spreading your investments too thin. The legendary Warren Buffett himself was once quoted as saying, Diversification is protection against ignorance. This makes almost no sense to someone with experience in this field.

Diversification is one of the most challenging aspects of investing. Sadly, there is no hard and fast method to it. When it comes to investing and diversifying, there is no one true path to take. Investing is making educated guesses about the future, therefore doing it accurately is essential. This is a form of metaphorical palm reading.

Because of the inherent difficulty in doing so, there is no foolproof strategy for making money in the stock market. Indeed, it is precise because of this dilemma that diversifying your portfolio is crucial.

Since nobody can know what will happen in the future, it stands to reason that every investor will make a bad decision at some point, especially when dealing with individual equities. Having a diversified portfolio reduces the risk of complete financial ruin from making even one bad investment decision.

Who therefore has the higher standard of logic? Who do you believe: Buffet and George Soros, who think diversification is for chumps, or the hundreds of financial gurus who preach a solid mix of assets as one of the main aspects of a healthy investment portfolio?

It’s a case of them both being correct and wrong at the same time. What matters is the investor’s motivations and perspective.

Why Diversify Your Portfolio?

Spreading your investment capital over many different types of financial instruments, industries, and assets is one way to reduce your exposure to risk. In this approach, the portfolio as a whole is shielded from the potential losses associated with a drop in the value of a single investment, industry, or asset class. Investing can be diversified in many different ways.

Within-Industries Investments

The risk of losing everything due to the abrupt drop of a single stock is all that can be mitigated by the first method of diversification. If you’re a tech investor, for instance, you wouldn’t put all your eggs in one basket by putting your money in just Apple or Amazon but rather a diverse group of tech firms. 

The company’s stock would plummet if iPhone sales were to suddenly dry up. It’s safe to say you’d lose a lot of money if you put all your money into Apple stock.

If, on the other hand, your money were dispersed over numerous different companies, whatever losses you could incur from Apple shares would be more than made up for by gains in other equities.

The Different Industries

The goal of diversifying into multiple industries is to cushion the blow of economic downturns that strike multiple related fields. Diversifying your portfolio across multiple sectors can help you weather industry-wide downturns.

Consider the.com bubble. Investors’ attention was highly concentrated on technology companies during the bubble. Investors were eager to back any venture that included the phrase “dot com” in its title. However, the dot-com bubble burst, just like every other market bubble before it. The entire technology industry suffered greatly as a result.

If you exclusively put money into technology and anything like this happens again, you could end up losing a lot of money. However, if you diversify your holdings across industries like tech, oil and energy, healthcare, consumer goods, and manufacturing, the gains from those areas would assist to cushion the blow of any losses in the technology sector.

The Different Asset Classes

Asset allocation refers to the practice of spreading your investments across different categories to mitigate the risk of loss from the collapse of an entire asset class. One need only consider the stock market’s past to see this. Numerous catastrophic stock market crashes have occurred over the years, and the state of the economy has usually been a major contributing factor.

It is common knowledge that when times are tough economically, people are less likely to put money away in the stock market, which can lead to catastrophic losses. If your whole investment strategy is based on the stock market, you should brace yourself for devastating losses during these periods.

Investors hedge their bets against these kinds of losses by putting money into a wide range of asset classes. They might diversify their portfolios away from stocks by purchasing fixed-income assets, precious metals, or both. When economic and market conditions are bleak, these investments tend to rise in value, earning them the name “safe haven.”

The Different Market Caps

Stocks with different market capitalizations also have different potential gains and losses. Small-cap equities, especially those with value features, have a long track record of outperforming their large-cap counterparts. 

Large market capitalization firms, on the other hand, tend to be more reliable. Thus, one must make a choice between taking on more risk and sacrificing possible profits.

Combining the two is the most balanced way to ensure a middle ground of good health. Small-cap plays have higher potential returns, and by diversifying your portfolio with large-cap holdings, you may take advantage of this opportunity while mitigating the market volatility.

What’s Wrong With an Investment Portfolio That Is Diversified?

Why are some of the most successful investors in history so opposed to diversification if it provides so much security? To hedge against catastrophic losses, it’s important to diversify your holdings across asset classes. However, this can limit your potential for spectacular gains.

People frequently make claims like, If you invested $10,000 in Amazon in 2006, you would have more than $1 million today. Absolutely no one can deny that. As of now, Amazon stock is trading at over 115 times what it was in 2006. Putting in a lot of money back then would have been a brilliant decision.

One major issue exists, and it’s the only one. The typical American has less than $9,000 stashed away in the bank, as reported by the CNBC site Make It. Therefore, the typical American has no wiggle room to invest in anything else after putting down $10,000 in shares.

Supposing a single investor has ten investments in their portfolio, all of the identical value, this is considered a lightly diversified portfolio. A 2006 investment of $1,000 in Amazon would be worth more than $115,000 today. 

Not a small sum, but not enough to make major changes in one’s life either. And it’s possible that some of those gains were offset by losses in one of the other nine assets. Actually, that’s the whole point of spreading your risk around, right?

The investor’s strategy of spreading their money around backfired. It’s possible that today’s investors might have more than $1 million if they had put all their money into stocks and bonds, but they probably have much less because they invested in fewer things. 

If the investor had taken even more steps to diversify, they would have had even less exposure to Amazon, and hence would have gained even less from the phenomenal run of this company.

The Argument Warren Buffett Is Making

The statement by Buffet contains a wealth of information. Primarily, diversification serves as a safety net. Though it saves money in the event of a catastrophic drop, this strategy can be very expensive during extremely bullish periods for certain equities.

It’s an excellent analogy as well. Consider this issue from the point of view of property insurance. Around 6% of houses with insurance filed a claim in 2017, per data from the Insurance Information Institute. Because of this, nearly all of those who paid for homeowner’s insurance ended up losing money because they never used it.

Taking such a broad view of insurance may not make much sense, yet it appears that the vast majority of Americans consider home insurance to be a mandatory purchase. The price that customers pay is for the assurance that their information is safe.

In his now-famous words, Buffet equates diversification with purchasing insurance. Rather than protecting themselves from a thief smashing a window or stealing valuables, investors here are merely insuring themselves against insufficient research. Nevertheless, as with any insurance, this one has a corresponding premium.

But the second half of the famous Buffett phrase, It makes very little sense for those who know what they’re doing, is just as pivotal. The concept is that if an investor takes the time to do their homework and fully comprehend their investing choices, they won’t need the safety net that portfolio diversification provides.

If a trader or investor were to conduct their own investigation in 2006, they might have discovered a trend. As consumer tastes shifted around the globe, more and more transactions were taking place in the digital realm each year.

Meanwhile, Amazon was rising to become a market powerhouse. With the rise of online shopping and the shifting preferences of consumers, it would have been wise to seek out solid investments in the e-commerce market. Amazon was emerging as a frontrunner, making it a natural choice for funding in this sector.

An informed investor may have identified a long-term investment opportunity and reaped returns of over a hundred times their initial investment if they had bought a lot of the stock. It’s likely that other similar chances are occurring right now, unseen by most investors.

So, according to Buffett and other investing gurus, you may avoid the need to diversify if you take the time to do the homework and understand what you’re getting into.

Which Then, Is Correct? Should You Diversify or Not?

Every single investor is different, with individual aims, skillsets, risk tolerances, and other characteristics. In short, there isn’t a universal solution to this problem. 

However, in order to determine whether or not diversification should be part of your investment strategy, you can do the following:

  1. Have You Just Started? According to Buffet’s comments, it’s not necessary to diversify if you have a good plan. However, there’s no need to feel bad about your inexperience or, for lack of a better phrase, your ignorance. When you’re just starting out in the market, it’s smart to spread your bets across several different assets. You can’t expect to make money by investing in just one or two assets unless you’re an excellent investor, and even experts make mistakes.
  2. Have a High Acceptance of Risk? It’s possible that even at your level of expertise, you still wouldn’t feel confident putting all of your resources into one single venture. Protecting yourself through diversity is essential, therefore skipping it increases your vulnerability to financial loss. No matter how well you think you know the market, diversification may still be a good idea if you’re not particularly risk-tolerant. Still, there are a sizable number of people who would rather take a chance on a larger return through more precarious investment tactics.
  3. Have you got a good nose for information? It’s a high-stakes gamble to put all your money into the market without diversification. Though there is no surefire technique to pick winning investments, you may increase your odds significantly with thorough planning and research. On the other hand, diversification is the way to go if you lack the time, energy, or interest to conduct an in-depth study on individual investment prospects. At the end of the day, there are a select few investors who can safely avoid diversifying their stock holdings at all. It could be tempting to put all of your money into a single stock that appreciates dramatically over time, but it would be terrible to lose it all due to something like an Enron-style scandal.

Assets to Take into Account When Portfolio Diversification

The key to successful diversification is to allocate your capital over a wide range of asset classes. For this, you must first be familiar with the various asset classes and investment vehicles at your disposal, both conventional and otherwise. 

Some of the most popular choices are listed below:

Classical Investment Tools

There are many possibilities for conventional investment vehicles.

  • National reserves. When people think about investing, the first thing that usually springs to mind is purchasing stocks and bonds listed on a domestic exchange. United States-based company stocks are the most widely held kind of investment capital.
  • Global Investments About half of the world’s total market capitalization is located in the United States. If you limit yourself to investing in U.S. stocks, you’ll be missing out on the opportunities in the rest of the world. Purchasing equities from overseas companies gives investors access to these prospects in other countries.
  • Money-Gearing Assets. Bonds, TIPs, and preferred stock all fall under the category of fixed-income assets. Consistent payouts to investors are what give these assets their category name. Moreover, they are among the most secure investments available, mitigating the effects of the stock market’s notorious volatility.
  • High-Quality Investment Money. Common examples of funds that fall into this category are mutual funds, ETFs, and index funds, all of which have earned high ratings from financial analysts. These funds take in money from many people and then invest it in line with their declared investment plan. Shareholders’ total returns are proportional to the number of shares they possess in the fund.
  • True estate. Real estate, one of the earliest asset classes, continues to be popular with financiers today. Real estate investment trusts (REITs) are an alternative to direct property ownership; they function similarly to high-quality mutual funds but invest in physical buildings and land instead of stocks and bonds. Fundraise and Groundfloor is two other investment platforms worth considering.
  • Metals of high monetary value. Gold and silver are two precious metals that have long been utilized by investors as a way to diversify their holdings and reduce portfolio volatility. These metals are used to protect against inflation.
  • Currency. Finally, the most sought-after commodity is money itself. Values go up and down, just like any other asset, therefore it might be a good bet for the proper investor.

Other Investment Vehicles

Investing through more conventional means has been the norm for a long time. But as technological progress alters the way we do everything, consumers are increasingly turning to nontraditional investment methods. 

Here are some of the most typical examples:

  • Art. Investing in the artwork is a high-risk venture because there is no way to predict its future demand. However, an art investor with a keen eye for high-end pieces and the innate sense to make sound purchases might stand to make substantial returns on their art holdings. Investing in art has never been easier than with online galleries like Masterworks.
  • Cryptocurrency. In recent years, cryptocurrency has gained widespread attention. Like the art market, investing in digital currency is a high-risk endeavor, yet many early adopters have amassed fortunes through such ventures.
  • Levys related to taxes. When municipal property taxes are not paid, a lien is placed on the property by the government. Interest-bearing debt can be used to buy one of these liens. You may be able to repossess the home and sell it to cover the debt if it goes unpaid.

Bottom Line

When it comes to argument, diversification is a topic that rarely comes up. While some of the best investors in the world avoid it, diversification is crucial for any trader, but especially for newcomers.

True, diversifying your portfolio’s holdings may reduce the potentially substantial returns you could earn over time from a single, well-chosen investment. Finding the stock that will explode in value is like looking for a needle in a haystack.

In retrospect, it’s easy to think, I should have invested all my money in Amazon back in 2006. Given the state of knowledge in 2006, it would have been risky to put all your eggs in one basket with that firm, and practically impossible to foresee its meteoric rise to prominence as one of the world’s largest corporations.

Finally, it’s easier to reflect on the past. While it may be simple to claim “I shouldn’t have diversified” in retrospect, actually making the choice not to diversify can be difficult and, in many cases, highly costly. Achieving success requires making small changes over time that add up to wealth in the stock market. It is wise to diversify your investments to safeguard your growing fortune.

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