Portfolio Management: Diversification
After the last post on correlation between stocks, you might have been thinking that this all seems to be leading to a post on the importance of diversifying your stock portfolio. But, in actuality, my intention is to blow a big hole in all the “Diversify, Diversify, Diversify” rhetoric that has long been fed to unknowing investors by mutual fund companies, stock brokers, and other uninformed investors who just want you to spend a lot of money in vain attempts to insulate your stock holdings from the market’s volatility.
First and foremost, diversification can at the very best only give your stock portfolio the same volatility as the stock market. A simple look at how major market indicators like the S&P 500 perform from year to year should tell you all you need to know. Even if you invested in all 500 S&P stocks, it is still more than possible to lose on the order of 20-40% in a particularly bad year. The stock market is volatile! No amount of diversification is going to insulate you from this. Targeting absolute returns year in and year out with an investment strategy that focuses completely around stocks is, in all likeliness an impossibility, especially for the average investor.
Diversification is a strategy which involves all of your investment choices and spreading your wealth in different kinds of securities and asset classes. Smart personal investing involves making informed choices about how much of your wealth should go in savings, bonds, real estate, CD accounts, and any of the many other investment options that are available to you. Realizing this, you realize that diversifying your stock portfolio is not necessarily a necessity. If you can’t take the risk, invest less in stocks and more elsewhere.
Don’t diversify your portfolio to the point that it is earning you only a few percentage points better than other gauranteed investment options despite exposing you to market risk. Instead, learn all you can about making smart stock picks and do your best to make a few good picks as opposed to many conservative picks. Plus, how much time are you really willing to spend trying to make informed decisions on dozens of stocks? Why not concentrate on a few and make strong, agressive picks? As far as stock investing goes, this has become my strategy. I do my best to mitigate risk by trading (sacriligious I know). I always evaluate my positions before quarterly earnings and rarely hold correlated stocks or stocks in certain volatile industries (transportation, almost any other industry dependent on oil, and many tech stocks) for more than a full quarter. This allows me to chase stocks which are performing strongly but without necessarily exposing me to the long term volatility involved.
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