Most basic articles on personal finance advise investing in a diversified portfolio. Diversifying investments is touted as reducing both risk and volatility. While a diversified portfolio may lower your overall risk level, it also reduces your potential capital gains. The more extensively diversified an investment portfolio, the more likely it is to mirror the performance of the overall market. Since many investors aim to beat the market, they may wish to revisit the issue of diversification versus concentration in their portfolio choices.

While diversification is a good way to preserve wealth, concentration is often a better way to build a fortune.

How to Diversify a Portfolio

There are several ways to attain diversification. One way is to diversify your investments among several different companies. It is also possible to diversify among various sectors. Owning stock in both a technology firm and an energy company provides more diversification than simply owning two tech stocks. More diversification can be achieved by investing in companies with varying market capitalizations. Returns are often different for small cap stocks and large cap stocks. Portfolio diversification can also be obtained by investing in foreign companies instead of just domestic firms. Pursuing different strategies, such as growth or value investing, also provides diversification.

The highest level of diversification can be achieved by investing in different asset classes. Bonds are far less volatile than stocks, and government bonds often go up in price when stocks go down. Commodities are another significant asset class with a different pattern of returns. Finally, buying and selling options on stocks, commodities, and other assets provides even more diversification.

The real question is to what extent investors should diversify their portfolios. The answer depends on personal goals, risk tolerance, and preferred investment strategies. Investors should consider the relative advantages and disadvantages of diversification within a personalized framework.

Advantages of a Diversified Portfolio

Diversification reduces an investor's overall level of volatility and potential risk. When investments in one area perform poorly, other investments in the portfolio can offset losses. That is particularly true when investors hold assets that are negatively correlated. For example, long-term U.S. Treasuries made significant gains when stocks declined in 2008. Diversification may also open up additional profit opportunities. For example, an investor who chooses to diversify with investments in foreign stocks can try to put funds into countries experiencing economic booms. Those shares can produce substantial gains at a time when the performance of domestic stocks is mediocre to poor. Such a situation occurred in the U.S. between 2003 and 2007, when foreign stocks consistently outperformed U.S. markets.

Disadvantages of Increasing Diversification

The problems with diversification are less publicized, and therefore less well known. The truth is that diversification can also have adverse effects on an investment portfolio. Diversifying an investment portfolio tends to limit potential gains and produce average results. An investment portfolio of five carefully chosen stocks can substantially outperform the market. Watering it down with dozens of other stocks leads to mediocre performance.

Another problem with aiming for broad diversification is that it may require extra work to rebalance your portfolio. 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 many investments. Diversification can even increase risk if trying to diversify leads an investor to become careless. In many cases, investors seeking high levels of diversification are better off with mutual funds or exchange-traded funds (ETFs).

Advantages of Concentrated Portfolios

One of the benefits of a more concentrated portfolio is that while it does increase risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are not usually widely diversified. Those with investments concentrated in a few companies or industries are better at building vast wealth. A more concentrated portfolio also enables investors to focus on a manageable number of high-quality investments. Wiliam J. O'Neil, Gerald Loeb, and Jesse Livermore built their fortunes through concentrated investments.

The Bottom Line

The best path for an investor may be to aim for only a modest amount of diversity while primarily focusing on selecting high-quality investments. These investments should be chosen using a preferred investment strategy, such as growth investing, income investing, or value investing. Personal risk tolerance and overall investment goals are also important. 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 meeting the personal goals and financial needs of the individual investor.