When the markets crashed in the early 2000s, Wall Street was quick to run to the television and tell America that investors were too aggressive and should have been more diversified. And yet, not a person in the world can tell you how much diversification you should have…or how much is too much.
A strategy to help reduce overall risk and volatility in a portfolio, diversification is the practice of buying a bunch of investments of differing types. Most diversification strategies have no regard for the quality of the investment or the price at which it is purchased because the generally accepted thinking is that you are better off being widely diversified than waiting for a great opportunity.
The problem with diversification is that investing is a zero-sum game-someone’s gains are always offset by someone else’s losses. It is impossible to make money owning an investment unless someone else (or many other people) loses that money. An example of this is a game of chess-it is impossible for both players to win.
If you were to own every investment in the world, you would earn exactly 0% because all of your gains would be offset by all of the losses in your portfolio. Though it is impractical to think you can own every investment in the world, the more diversified your portfolio becomes, the closer you come to earning a 0% return.
So, how diversified should you be? Why not concentrate your portfolio in a few truly wonderful investments? If you understand how businesses grow, how to value a business, and how to spot problems and opportunities, the thought of diversification for the sake of diversification becomes silly.
Filed under: How to Think About Investing
Iskander, that depends on whether you are considering the prior / earlier average or the current average during an expansion. If comparing current growth rates to prior growth rates, yes, it is possible for everyone to benefit (a rising tide lifts all boats). If, on the other hand, you mean it is possible for everyone to exceed the average in real time, this is not possible. Even in the rare case where the average falls between a large cluster of those exceeding the average with one significant outlier falling well below the average, that one outlier is necessary to create such a favorable average. At that point, however, the average ceases to have informative meaning, and it is why statisticians spend so much time considering the outliers (often called “residuals,” which is technically a statistical term for data points exceeding three standard deviations from the mean).
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Joe,
I’m not sure what you’re getting at with this one. Diversification would only result in a zero-sum game if no wealth was ever created. If you were invested in every company in the 1950s, you would certainly be wealthier now.
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well it all depends on the correlation between the stocks you have choosen many big mutual funds are having the same problem.I think some people try too much to remain secure but in a wrong way.
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Do you not mean that the more diversified your portfolio, the closer you come to earning market average?
The world is not zero-sum. Neither is the stock market. When wealth is created, it is possible for everyone to gain. It’s just impossible for everyone to make above average returns.
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