Is Diversification Good?

Is Diversification Good?

Most of us have probably heard about diversification and always assumed it was a good thing. We’ve always been more worried about how to achieve diversification rather than whether to do so. Let’s go ahead and upset the apple cart here and investigate a basic question: Is diversification good?

What Is Diversification?

Like so many other financial terms, you probably have a pretty good idea of what diversification is, but might have trouble explaining it to someone. Diversification is reducing the risk in your investment portfolio by mixing the type of assets you own. Sounds simple and reasonable, right? So why do we need to look further?

One thing most people don’t question is what actually constitutes diversification. Many people might buy several different stocks thinking they’re reducing their risk, but what if all those stocks are in the same industry? What if those stocks are all affected by the price of the same commodity, like oil or steel? Can you even claim to be diversified if all your money is in stocks? What about exposure to your home country? If all your assets are in your home country, are you protected against a crisis there?

Do I Want to Be Diversified?

As you can see, trying to figure out whether you’re truly diversified is a non-trivial matter. Even if we can figure out how to be diversified, do we want to be? The short answer to that question is: It depends on whether you’re right about your investment selection.
If you could pick the one investment that you knew was going to do better than any other investment over some period of time, why would you want to be diversified? You’d want to put all your money in it. Heck, you’d want to borrow money to put into that investment. Unfortunately, no one ever knows anything for certain, and often people are very wrong even when they’re very confident.

Think of diversification as your worst case scenario defense. The more investments you have, the less likely you are to have picked the worst one. This doesn’t mean you want to invest in anything and everything. Your objective is to put together a group of investments that all have potential. If all your picks have solid research and knowledge behind them, you’ll probably hit on more than you’ll miss. So your objective isn’t simply diversification, but well-thought-out diversification.

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Balance Junkie's picture

Balance Junkie wrote:

Sat, 10/23/2010 - 13:53 Comment #: 1

You hit on the most basic questions we need to ask about diversification. In my experience, the basic questions are always the best ones.

Welcome to the financial blogosphere and thanks for upping the estrogen quotient!

MomVesting's picture

MomVesting wrote:

Sun, 10/24/2010 - 23:44 Comment #: 2

Thanks for the welcome! The basics are always going to be a key to getting people who might not feel comfortable with finance in the door. We hope that by giving them some coverage we'll make the world of finance and investing less intimidating.

Financial Planning and Personal Investment | Personal Invest's picture

Financial Planning and Personal Investment | Personal Invest wrote:

Fri, 10/29/2010 - 05:58 Comment #: 3

[...] presents Is Diversification Good? posted at MomVesting, saying, “Most of us worry about how to be diversified, but is that the [...]

MoneyCone's picture

MoneyCone wrote:

Fri, 11/05/2010 - 19:30 Comment #: 4

To add to that, ETFs are a great way to stay diversified. Buying individual stocks can get expensive with commissions and Mutual Funds can get expensive with expense ratios - ETFs strike a good balance.

In Praise of Imbalance | Balance Junkie's picture

In Praise of Imbalance | Balance Junkie wrote:

Fri, 11/12/2010 - 10:21 Comment #: 5

[...] of balance, and honestly we are too. We believe diversification is good, but only when it’s good diversification. Let me explain. Even in the case of a well-diversified portfolio, sometimes all you’re doing is [...]