Is Too Much Diversification Hurting Your Returns?
Potential investors spend a lot of time researching the “best” investment options. An experienced investor understands that there isn’t exclusively one way to grow your wealth. You could invest in stocks, bonds, real estate, precious metals, and even cows (yes, actual cows). Every option comes with its own advantages and disadvantages, so it’s hard to determine what your holdings should be on your own.
At Emperor, our favorite investment option is to invest in the stock market, specifically in dividend paying stocks. But in general, equities (stocks) are often thought of as offering higher returns while being more volatile (“risky”). However, there is an age-old investment principle that can help minimize that risk: diversification.
Diversification is a method of managing risk by investing in assets that do not all move in tandem. Most commonly this involves incorporating different investments within your portfolio. The rationale is straightforward, a portfolio constructed of different investments will not fail as a whole if a single investment (or group of investments) fails. Simply put, diversification is the idea of “not putting all your eggs in one basket”.
A good analogy to explain diversification is the classic fairy tale, Little Red Riding Hood. Think of Little Red as an investment, the Big Bad Wolf as all the factors that influence investments, and a basket of eggs as money.
If Little Red were attacked by the Big Bad Wolf while bringing a basket of a dozen eggs to her grandma’s house, all of the eggs would be lost and her grandma would starve. However, if Mama Riding Hood read this post about diversification, she might send Little Red along with her three sisters. Each girl can then take three eggs and a different path to Grandma’s house. If one of them gets attacked, Grandma would still be fed by the remaining (now traumatized) Riding Hood sisters.
Let’s assume that the probabilities for each scenario are divided equally. In the first scenario, Grandma has a 50% chance to get 12 eggs and a 50% chance to get 0 eggs. In the second scenario, Grandma has a 20% chance to get 0, 3, 6, 9, or 12 eggs. Therefore, Grandma is more likely to get 12 eggs in scenario one than she is in scenario two. Obviously investing is more complicated and is rarely all or nothing, but you can see that the more you diversify, the less likely you are to lose or gain.
There’s a difference in diversifying across investment options and diversifying within an investment option. In our opinion, diversification across investment options (e.g. having a portfolio of stocks, bonds, and precious metals) is more suitable for beginners. Look at it this way, if you know that one investment option historically performs better than others, then why invest elsewhere? That option has again and again been proven to be the stock market. So all you need to do is diversify within the stock market and you’ll be set, right? Unfortunately it’s not that easy.
On top of knowing which paths (i.e. industries and sectors) are dangerous (i.e. volatile), you would also need to do research on the thousands of companies listed on the different stock exchanges. Therefore, even financial advisors will usually offer two types of funds for people who want equities in their portfolio. Mutual Funds pool money together from every client, buy shares of companies, and pay out returns based on the performance of the fund. Exchange Traded Funds (ETFs) are similar, however they trade just like stocks, meaning that your money isn’t pooled with others. There are many reasons we don’t like funds, and you can read about all of them here. But in the context of diversification, we find most funds too diversified and returns suffer as a result.
How We Diversify Without Endangering Returns
There is no way to tell when a company could take a huge hit for an unexpected reason. So while it’s true that nobody can predict the future, we can learn from the past. At Emperor, instead of over diversifying, we only buy dividend stocks. All of the companies we invest in have been paying dividends consistently for a very long period of time. For us, that shows stability (i.e. a ‘safe path’) since a dividend is a redistribution of profits to shareholders.
Furthermore, dividends could also be seen as a source of passive income. While dividend stock payouts cannot be guaranteed, the fact remains that the companies we pick haven’t even reduced dividends since beyond the 2007/08 financial crisis. This means that even if the value of your stocks fluctuates, you are still likely to receive passive dividend income while you wait for the market to rebound. In addition to dividends, we also diversify our portfolios across industries and market sectors. Some of our favorites are Utilities and Consumer Staples, while we avoid volatile industries like Airlines. Combining these factors, we believe our portfolios are less volatile even though they are more focused; containing between 13 and 40 companies.
You could also lower your volatility and keep Little Red and her sisters alive by following a dividend investing approach. But if you want to save a huge amount of time constructing a pure equity portfolio and adjusting it as time passes, you can start investing in stocks today by clicking here.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Originally published at https://www.emperorinvests.com on April 4, 2019.