Investing diversification is a subject of much debate in personal finance, and it is my view that investing diversification (as traditionally understood) is not really a good thing. In this article, I explain why.
Warren Buffett once remarked,
Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.
This is probably why Buffett only holds around 20 stocks in his investment portfolio. By today’s standards, that would be considered grossly “under diversified.”
But is under diversification really a problem?
To answer that question, let’s look at what diversification actually is.
What is diversification?
Investopedia defines diversification as follows:
Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories.
I like that definition, and it’s as good as any out there.
The main goal of diversification is to minimize risk, so you might be wondering, “How can that be achieved?”
How is diversification achieved?
Many experts believe that the key to minimizing risk has to do with spreading out investments across both stocks and bonds – foreign and domestic.
That is why most target date retirement funds do this for you automatically.
For example, notice the 4 different holdings in this Vanguard Target Retirement 2050 Fund:
Most financial advisors would call this “well diversified.” It has holdings in stocks and bonds in both foreign and domestic markets.
The biggest advantage to diversification of this sort – once again – is to minimize risk.
For example, if there is volatility in stocks, the bond funds (in theory) should stabilize the volatility and mitigate loss – which is to, essentially, minimize risk.
That means the volatility might not have as negative an impact on your overall rate of return.
While that sounds great, it does come with a cost worth consideration.
Why is diversification bad?
The biggest disadvantage to diversification is how it will affect your overall rate of return.
You’ve heard the old adage, “With high risk comes high reward.” Well, the opposite is also true, “With low risk comes low reward.” And if the reward is your rate of return on investment, we certainly don’t want that to be low.
Take, again, the Vanguard Target Retirement 2050 Fund.
Since it invests in foreign and domestic stocks and bonds for the greatest amount of diversification, the returns overall suffer as a result.
Take a look at how that fund compares to an index like the S&P 500 that follows the overall market:
It’s not terrible, but it’s not great, either. And that’s because it has holdings in underperforming bond funds.
Or look at how those bond funds compare to the S&P 500:
It’s easy to see how the market outperforms both bond funds, foreign (bottom) and domestic (top).
So if you plan to diversify for maximum diversification, your returns could suffer.
It’s important to mention that there are other ways to “diversify” without having to invest in underperforming bond funds.
Other ways to diversify
Earlier I mentioned that you can diversify by spreading out your investments across stocks and bonds in foreign and domestic markets. But you can also diversify in other ways.
To diversify, simply means not to put all your eggs in one basket. But that’s pretty easy to do when it comes to investing.
As long as you are investing in multiple companies, an argument could be made that you’re plenty diversified.
For example, owning 5 stocks is more diversified than owning 1 stock, and it’s less risky. If 1 or 2 stocks lose money, while the other 3 make money, you might still come out ahead. Therefore, it’s less risky than going all in on 1 stock.
An easier way to do this might be with a mutual fund – where you own shares in 10s, 100s or 1000s of different stocks.
As long as you’re not going all in on 1 company, you are considered somewhat diversified.
How much you want to diversify is up to you, but there does seem to be a point where too much might hurt you. So be mindful of that.
How should you diversify?
I have always been a fan of the mutual fund approach. These are the types of investments that would be available in a company 401(k) or personal IRA – something like that.
Related: Best Vanguard Funds for Roth IRA
I like mutual funds because they allow you to hold shares in multiple companies across different sizes and sectors.
I have mutual funds with 60-70 stocks; I have mutual funds with over 3000 stocks; all of which are plenty diversified as you can imagine.
I don’t own, nor do I recommend, bond funds because they don’t perform as well as the stock market does.
Like I said earlier, bond funds will likely hurt your overall returns, so you are probably better off without them.
That’s also why I don’t recommend target date retirement funds because they usually hold shares in bonds.
If you have a company 401(k), you might want to see what fund(s) your invested in (most employers will use target date funds by default).
If you are invested in target date fund, you might consider changing it (most employers will have other options available).
Related: Best Funds for Your Company 401(k)
I would strive to find a fund (or funds) that holds shares in 100 percent stocks that can either match or beat the market. It’s easy to figure by looking at the fund’s track record and then compare it to the S&P 500 (or some other market index).
For the most part, I follow the philosophy of Dave Ramsey when it comes to investing.
Here is a quick video that can help you understand the types of investments I’m talking about:
Remember, diversification is meant to minimize risk, but not at the expense of your return.
Of course you can’t eliminate risk entirely – that wouldn’t be investing! So even “risk” is a moot point.
The goal, then, should be to find a happy medium, where you feel comfortable with the balance of risk and reward in any particular investment.
For most people, a good mutual fund will do the trick.