Most basic articles on investing advise having a diversified investment portfolio. Diversifying investments is touted as reducing both risk and volatility. However, while a diversified portfolio may indeed reduce your overall level of risk, it may also correspondingly reduce your potential level of capital gains reward. The more extensively diversified an investment portfolio, the greater the likelihood it, at best, mirrors the performance of the overall market. Since many investors aim for better than market average investment returns, they may wish to revisit the issue of diversification versus concentration in their portfolio choices.
Ways to Diversify a Portfolio
There are a number of ways to attain some level of diversification. One is simply company diversification, which is owning stock in more than one company. A portfolio can also be industry diversified. Owning stock in both a banking company and an insurance company is more diversified than simply owning two bank stocks. Further diversification can be achieved by investing in more than one market sector. Another means of diversification is to own stocks of companies with different levels of market capitalization, from small- to large-cap stocks. Portfolio diversification can also be achieved by investing globally rather than just in domestic stocks. Investing in different asset classes, such as stocks, bonds and futures, also creates diversification. Finally, investing choices based on varying trading strategies, such as growth investing and value investing, also provide diversification.
The real question for investors is to what extent they should diversify their investment portfolios, and the answer is that each individual investor should largely be driven by his personal investment goals, level of risk tolerance and choice of investment strategies. Investors should consider the relative advantages and disadvantages of diversification within that personalized investment framework.
Advantages of a Diversified Portfolio
Diversification reduces an investor's overall level of volatility and potential risk. When investments in one industry, market sector or asset class perform poorly, other investments in the portfolio with a negative correlation to the poorly performing investments should perform relatively better and at least partially offset losses and reduce the portfolio's overall volatility. Diversification may also open up additional profit opportunities. For example, an investor who chooses to diversify his portfolio with investments in foreign stocks may find he has invested in the stocks of countries experiencing economic booms, and those stocks produce large gains at a time when the performance of domestic stocks is mediocre to poor.
Disadvantages of Increasing Diversification
The disadvantages of diversification are less publicized, and therefore less well known, but the fact is diversification can also have adverse effects on an investment portfolio. Overly diversifying an investment portfolio tends to reduce potential gains and produce only, at best, average results. If your investment portfolio contains five stocks that are performing wonderfully, but 45 others that are not doing well, those stocks may substantially water down the gains realized from your best stock selections.
Another problem with aiming for broad diversity is it may require extra transaction costs to rebalance your portfolio to maintain that level of diversification. A widely diversified portfolio with a lot of different holdings is generally more trouble to monitor and adjust since the investor has to stay on top of so many different investments. Diversification can even increase risk if diversifying leads an investor to invest in companies or asset classes that he knows little or nothing about but have been added to a portfolio solely for the purpose of achieving diversification.
Advantages of Concentrated Portfolios
One of the advantages of a more concentrated portfolio is that while it does increase risk, it also increases potential reward. Investment portfolios that obtain the highest returns for investors are not typically widely diversified portfolios but those with investments concentrated in a few industries, market sectors or asset classes that are substantially outperforming the overall market. A more concentrated portfolio also enables investors to focus on a manageable number of quality investments.
The Bottom Line
The best path for an investor may be to aim for only a modest amount of diversity while putting his primary focus, not on diversification, but on selecting high-quality investments chosen in accord with his preferred investment strategy of growth investing, income investing or value investing; his personal risk tolerance level; and his overall investment goals. While some level of diversification should be a consideration in constructing an investment portfolio, it should not be the driving concern. The primary focus of an investment portfolio should always be on putting together a portfolio designed to best meet the personal investment goals and financial needs of the individual investor.