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Optimal Investment Diversification

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Conventional Diversification

So, how much should an investor diversify their investments?  We've all heard the phrase "never put all your eggs in one basket."  Whether you're a newly minted investor or a bona fide investor superstar, you have at least some familiarity with the concept of diversification.

Conventional diversification holds that a well diversified investment strategy is a sure way to reduce risk!  Spreading your money among different types of investments is less risky than putting all your eggs in one investment basket.  If some of your holdings go down, others go up, and vice versa.  The basic theory to reduce risk is to invest in several types of investments and over various time horizons.

I agree with this premise to a certain extent. But let's analyze this a bit more deeply...

Diversifying for Business Cycles

The primary motive for diversifying your investment holdings is to minimize risk.  A large part of that reasoning stems from the ups and downs of the economy, which is the basis of the business cycle.  A strong economy is reflected in an expanding business cycle. When business is good, profits are up, and people tend to buy more because they have more money to spend.  Stocks and real estate react by increasing in value and return.  In contrast, when business is on the decline, stocks and real estate tend to be off as well.

Growth-oriented, discretionary, and more speculative investments do well when the economy is booming - companies that sell products or services that people can generally do without. On the other hand, companies that provide staple products/services such as food and healthcare have better ability to withstand recessions because people still spend money with these companies during those downturns.

In other words, some businesses are essentially recession-proof.  Even if the economy is on the decline, these businesses still tend to do well!  Such businesses include healthcare, food manufacturing and supply, transportation, infant care , energy, repair services, financial services, legal services and others.  From a consumers' perspective, people still need these products and services.

The economy may be declining, but people still have to eat, and they still need to get to & from work, etc.  So, investing in  some companies in these types of industries can potentially help to offset the decline in value of other companies that tend to be superstar performers during economic booms like technology, construction, and retail companies.

So, many investors try to balance their investment portfolio by having a mix of growth-oriented, speculative investments along with more stable companies in recession-proof industries.

Other Diversification Strategies

There are a number of other methods that investors use to diversify in effort to potentially minimize investment risk and maximize returns!

  • Investing in Different Types of Investment Vehicles - average returns vary across investment vehicles. While common stocks as a whole have, on average, historically performed the best over time, other investment vehicles such as real estate, bonds, mutual funds, certificates of deposits (CDs), options, currencies, ETFs, etc, also have the potential to produce very solid investment returns.  Investing in different types of investment vehicles helps to diversify your overall investment portfolio.
  • Investing in Different Sectors - having some investments spread across different sectors of the business landscape such as consumer staples, consumer discretionary, healthcare, energy, technology.
  • Investing in Different Industries - having a diversified portfolio of investments across different industries within a sector. If you're investing Tech, perhaps having investments spread across semiconductors, cloud computing, or ecommerce, for example.
  • Investing Internationally - some investments may be focused solely on the U.S. while other investments may incorporate an international basis in other countries.  Investing internationally can add valuable diversity, but it also can add risk in the form of unmanaged currency exposure.
  • Short-term vs Long-term investments

Overdiversification

So, how much diversification is necessary?  Is there such a thing as overdiversification?

While I do believe that investment diversification is useful to some extent, my thinking on the concept has evolved over the years.  Diversification is a useful technique, but I think that diversification is no substitute for having a thorough understanding of your investments!  In my view, the primary way to minimize investment risk is to always do your due diligence and adequate research upfront, and have strong firsthand knowledge of your investments.

With conventional diversification, you run the risk of overdiversification.  At some point, you become overwhelmed with trying to manage all the eggs in all the baskets.  You run the risk of putting too much in a company or an investment you're unfamiliar with.  Taking time to develop a thorough understanding of the business investment is far more effective in minimizing your risk than endless diversification! Know your investments!

2 Common Current Approaches

  1. Active Portfolio Management
  2. Index Investing

The underlying goal of both approaches is the same:  to minimize risk through diversification.

Active portfolio managers are constantly monitoring an excess number of investments and are buying/selling investments at a rapid pace based on market factors.  It's typically a client-based approach used by wealth managers, hedge fund managers, day traders, and the like.  The rationale is the more investments in their portfolio, the better the chances of remaining protected against loss.

In contrast, index investing, is a long-term approach that entails a buy-and-hold strategy.  It involves developing and holding a broadly diversified portfolio of investments based on a specific benchmark index, such as the S&P500 or the Dow Jones Industrial Average.  This type of approach can indeed be very useful and effective for novice investors.

Historical results of both approaches have provided, on average, mediocre results.  While diversification is certainly prevalent in either approach, neither typically provides you with exceptional results.

A 3rd Recommended Alternative

Consistent with my assertion above about doing your due diligence and developing a firsthand knowledge of your investments, I believe the best strategic approach to diversification is focus investing.

Focus investing, in contrast to the aforementioned two more common approaches above, entails the following:

  • Choose a few stocks (or investments in general) that are likely to produce above-average returns long-term
  • Have a thorough understanding of these investments, and focus the bulk of your excess cashflow for investment in these
  • Hold steady through business cycles and short-term market fluctuations

Of course, the investments chosen will have been adequately researched and you'll have a strong understanding of them, and they'll also have a long history of superior performance and stable management.  This will increase the likelihood of superior performance in the future as well!

Focus your investments in companies and opportunities with the highest probability of above-average performance, rather than overdiversifying.  For the average investor, a genuine case can be made for investing in 10 to 20 companies.  Those companies with the highest outlook for superior returns should have more investment capital allocated to them.  

Even Warren Buffett says that the ideal portfolio should contain no more than 10 stocks.  And according to his book Principles, investor Ray Dalio says that the quality of an investment portfolio (measured by the amount of return relative to risk) will improve incrementally if investments are added with different risk correlations. But the addition of such investments only add value to a point.  

Ray Dalio established The Holy Grail, confirming that 15 to 20 good, uncorrelated return streams can dramatically reduce risk without reducing expected returns. Any additional investments to the portfolio beyond that level could still be beneficial, but there is diminishing value of their impact as the number increases.  

Summary

There are many great investments out there to identify and invest in. To minimize risk and maximize returns, diversification can prove to be a useful strategy but be careful not to overdiversify!

  • Research your investments upfront to develop a thorough understanding of them
  • Diversify your investment holdings via focus investing approach
  • Focus on investments with the highest potential for above-average returns and strong long-term economics
  • Develop a portfolio of investment streams, ideally of no more than between 10 and 20 in number
  • Stay the course for the long-term to defer capital gains tax hits and leverage the power of compounding

Disclosure/Disclaimer

The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.

http://www.raisinginvestoriq.com/strategy/optimal-investment-diversification

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