Diversification is preached by everyone in the finance industry. It's a way to reduce your investment risk and give you exposure to a number of different asset classes. For some investors however, diversification can be a bad move. Depending on the amount you have to invest and your investment knowledge, diversification could be impractical and way more costly than you would think. Here are six problems with diversification. (For a background, check out The Importance Of Diversification.)
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1. Diversification requires a lot of money to get started.
If you want to have a truly diversified stock portfolio, it could end up costing you a pretty penny. Do you think $10,000 is a lot of money? Not at all! It takes at least $10,000 to be properly diversified amongst different stock sectors. It would cost $10,000 if you just placed $1,000 in a stock in technology, real estate, oil and gas, healthcare, consumer staples, retail, financial, transportation, natural resources and a cyclical stock. Ten-thousand dollars would buy you the minimum exposure to all of the largest sectors in the market.
2. Diversification is time consuming.
It can be a full-time job keeping up with the prices of stocks in different industry sectors. You have to be an informed investor which means staying up to date with major news, listening to conference calls and reading quarterly reports for important information. This can be quite a time commitment. You may feel overwhelmed trying to keep up with the ins and outs of your portfolio on a weekly basis. (For more, check out The 4 Key Elements Of A Well-Managed Portfolio.)
3. Diversification can make investing more expensive.
In an attempt at rapid diversification, new investors have a tendency to load their portfolio up with blue chip stocks. The problem with buying big name companies is that they tend to be more expensive than mid and small cap stocks. Mutual funds, hedge funds and institutional investors are professional investors and they all buy the blue chip companies. You will end up paying a premium to buy a slower growth household name.
4. Diversification can be a tax nightmare.
The more stocks you own, the more 1099 DIVs and broker statements you will receive. This can make doing your taxes an ever bigger headache. You have to list every buy and sell transaction along with any distributions from your stocks during the year. That is exactly what you do not want, a way for your taxes to become even harder to do. (Check out 10 Steps To Tax Preparation for some tips.)
5. Diversification can hinder your ability to beat the market.
Most large cap companies have at least 30 analysts that follow the stock. These analysts spend their days researching and examining company data. They look at everything from financial data to industry trends. Companies that have a lot of analysts following them have a hard time exceeding analyst expectations, which makes big price moves less likely. Small and mid-cap stocks give individual investors the best opportunity to outperform the market.
6. Diversification can ruin your best ideas.
In some cases diversification can actually hurt the return on your portfolio. If you divide your portfolio up equally amongst all your investments, your best ideas may not get enough attention. You are actually allocating the same amount of money to your best ideas and your worst ideas! Your best ideas deserve a much larger chunk of your money than your worst ones. (For more on this, see The Value Investor's Handbook.)
The Bottom Line
Diversification may be touted as a one stop strategy that fits everyone due to its risk reducing aspects. However, some investors may find that diversifying their portfolio can be more expensive, complicated, and hurt their overall returns. For these investors, diversification would actually be diworsification.
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