When it comes to portfolio diversification, investors are taught from an early age that they should not put all their eggs in one basket. By investing in a well-rounded portfolio you can still maintain your returns while decreasing your risk.
What does that mean in practical terms? Think about a portfolio where you had put all your money in General Electric (GE) for example. Over the past two years, GE has lost almost 60% of its value. If that was your one holding, your portfolio would be worth 60% less than it was two years ago. On the other hand, if you had 5 equally-weighted stocks, then the GE losses would still hurt, but not nearly as much. And if the other 4 stocks were up—your portfolio might actually have made money.
Portfolio diversification should handle not only bad company mismanagement, but also mitigate the impacts from other shocks to the market, such as:
- Industries that fall into disrepair (Energy)
- Industries that are susceptible to Inflation (Consumer Discretionary)
- Industries that are impacted by high interest rates (Real Estate)
- Companies (and industries) that might be hit by trade wars (Tech)
So to really diversify, it is important to not just buy more stocks, but also move some of your money into sectors of the market that will protect the investor from the above swings.
Sometimes that is easier said than done. So below, I have put my list of the most common portfolio diversification mistakes that an investor can make:
Owning 10 Technology Stocks:
Tech has been on a hot streak, and there are plenty of household names that all have terrific track records. It is not uncommon to see an investor buy 10 of the stocks, and think that he has diversified his risk away. Wrong! Trends in the market come and go. Tech stocks are not immune to the changing moods of investors, and they can be out of favor as quickly as they have been in favor. A good example is the fourth quarter of 2018 where the Chinese trade war kicked up and dropped tech stocks much faster than all other sectors. Tech is fine, and should be part of a portfolio, but in moderation.
Holding Stocks In Covertly-Related Industries:
Airline stocks and Auto stocks are completely different right? One is related to business and leisure travel and one is a major household purchase, so they should be good diversified industries, right? NO! Once again, these two industries are beholden to energy prices. When prices at the pump go up, both of these industries hit the skids. So, while it is fine to own a stock in each industry, be aware of the connection, and realize that you are not fully diversified.
Diversifying with a Crazy number of stocks:
I love this one. If some portfolio diversification is good, owning 50 stocks must be completely risk free. That is true to a certain extent. If each holding is 2% of your portfolio, you won’t be hit with any massive loss due to a single companies mismanagement. On the other hand, you will be getting very close to just owning an index ETF—and that would be a lot less worry. Managing 50 positions requires time and energy. You probably are not able to really spend the appropriate care to select 50 great companies.
Portfolio Diversification for Diversification’s sake:
Diversification is important, and it should be a part of your investment process. However, it doesn’t mean that you should invest in weak sectors of the market solely for diversification. For example, energy stocks have been beaten down for over a year with no hope in sight. Even though energy stocks represent a great hedge for an airline stock, this probably is not worth adding a dog to minimize risk. Dogs should be the big furry kind, not the bad stock kind.
Keeping a balanced portfolio healthy takes some care. Just like a healthy diet, a varied set of stocks will keep your portfolio healthy just like a varied diet keeps your body healthy. Avoid the above mistakes, but by all means diversify. You will sleep better at night, and enjoy watching your portfolio grow!