Portfolio Diversification: A Quick Tip To Do It Better

“Wide diversification is only required when investors do not understand what they are doing.”
 – Warren Buffett

 

 We've all heard the old idiom, "Don't put all your eggs in one basket." For more than five decades, portfolio diversification has been considered a basic building block of any investment portfolio -- with the critical function of reducing risk and dampening volatility. There is a trend toward what may be deemed over-diversification. Should you own a stock in your portfolio to dampen volatility or because of positive underlying fundamentals of a company?

Diversification Is Important

portfolio diversificationEveryone knows that diversification is important. Too often, though, diversification comes first and investments come second. I believe this is backward. Case in point, I've seen portfolios that own everything. For example, if you own 20 mutual funds diversified across several countries, the underlying holdings could be 2000 stocks and 10,000 bonds. When you own entire markets rather than individual securities, there is no doubt that you're diversified. The trouble is that you don't truly know what you own.

Buy and Hold Great Businesses

In my career, I have spoken with many great investors. Do you know what they had in common? They invested in the great businesses that grew for 30 or 40 years, and beyond. They did not want to own an index of 2000 companies. Another important point is that stocks are inherently risky. The reason to diversify is to mitigate risk. When bear market cycles come, you better be confident that your stock portfolio is made up of companies that will survive and come back. Great investors have the wherewithal to hold on to their investments through tough times so you should own businesses that you are passionate about, ones that you really believe in. Or if you work with an advisor, your advisor better feel that way about the holdings in your portfolio.

Invest first, diversify second -- and you'll have a good chance of being a successful investor in the long-term.

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photo credit: Diversification - Investing via photopin (license)

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About the Author: Andrew Wang

Andrew Wang

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