When it comes to diversifying your investment portfolio, it’s important to evaluate all sides of the strategy before committing to one approach over another. While investment professionals often recommend the approach for its ability to reduce risk and volatility, it could also minimize the level of returns generated. When determining the extent you should diversify your portfolio, consider your own personal investment objectives, preferred risk tolerance and strategy options. As with any important financial decision, you want to first make sure you consider both the advantages and disadvantages of each approach before making a final decision.
Especially when preparing for your retirement, it’s important to invest your money, as well as save it. According to the Government Accountability Office (GAO), in October 2017, the median retirement savings for Americans who are between the ages of 55 and 74 translated to only $310 per month if the money were to be invested in an annuity protected by inflation.1 However, by September 2018, the Transamerica Center for Retirement Studies reported that the total household savings in retirement accounts owned by Millennials, Generation X and Baby Boomers had dramatically increased when compared to the pre-recession.2 There’s no doubt people have become more conscious of how much money they’re accumulating each month as they approach their post-employment years.
While diversification is a routinely suggested practice among investors, as one might guess, there are significant pros and cons to the approach.
The Advantages of Diversifying Your Portfolio
As mentioned previously, reducing risk is one of the key reasons you might decide to diversify your portfolio. While risk can’t be eliminated entirely, diversifying your portfolio can help you manage your overall level of risk and minimize your chances of losing large sums of money over time. When you don’t diversify among your asset classes, you become even more exposed to market risk.
To go along with reducing risk, diversification also allows you to hedge your portfolio, which is an automatic benefit of refraining from putting all of your eggs in one basket. By investing in a variety of sectors, you even out your chances of getting positive and negative returns, as opposed to purely negative.
An alternative to capital appreciation, capital preservation is another benefit of diversification. Instead of focusing on your rate of return, capital preservation is all about protecting the money you already have. Because diversification involves investing in a variety of stocks, bonds and mutual funds, it makes it easier for you to protect the wealth you’ve already saved and accumulated.
The Disadvantages of Diversifying Your Portfolio
While diversification sounds like a dream come true, there are significant disadvantages that accompany the popular investment approach. For example, when you diversify, you increase the chances of investing in lower quality stocks, which reduces your margin of safety. Similarly, the more stocks you have to keep track of, the more likely you’ll fall behind on managing them, or at least being aware of where they stand.
What an amateur investor may not realize is that when you have too many assets in your portfolio, it essentially turns into an index fund, which can be invested on its own entirely to reduce transaction fees. When it comes to costs, transaction fees, as well as high mutual fund fees, can result in below average returns.
The Key to Investment Success: Finding Balance
When it comes to proper diversification, it’s important to allocate your money according to valuation, not some overly-hyped Wall Street formula. This may result in you holding onto your money when good deals aren’t necessarily ready and available. And if you’re primarily concerned about over-diversification, it’s important to note that over-diversification can result when you’re investing in mutual funds and ETFs.
As a general recommendation, it’s always a good idea to focus on high-quality businesses whose stocks are priced at valuations that put the chances of success in your favor.