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Why Diversifying Isn’t Always Necessary For High Stock Market Returns

The following is a guest post by Ryan.  He brings up a great point about diversification in the stock market isn’t always the best option.   Without further ado…

In an era where financial markets market can fluctuate quickly and extremely, fortunes can be won or lost in an instant. However, smart investors try to minimize this risk through diversifying their investment holdings. Diversification is the process by which an investor chooses a mix of investment types that will experience fluctuations in the financial markets at different rates and times. Hopefully, if the investor has chosen wisely, when one investment is doing poorly or takes a huge loss, another investment is making gains that minimize the overall loss.

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One mistake that many investors make is trying to use diversification as a way to try to beat the market. Trying to shift assets into other classes that will perform better in the short-term is just another form of speculation and is not a smart move when you are trying for stability in your assets and long-term gain. Remember the big picture.

Another mistake investors make is falling victim to the buffet mentality (not to be confused with Warren Buffett!), just because it’s there doesn’t mean that it is good for your set of circumstances. Too much diversification leads to disorganization. Portfolios can become difficult to manage and fees can get expensive.

Stocks and bonds should be the cornerstone of your investments. Before you diversify, make sure that you have the right mix of bonds and stocks and that the quantity of those holdings is correct. Obtaining the correct mix is dependent on a variety of factors such as how long you have until you retire, and how much risk you are willing to take. People who are closer to retirement age, and don’t want to see a sharp dip in their assets, should choose a higher mix of bonds over stocks. Yes, they will get lower return on their investment; but, they will also benefit from added security. Younger investors, on the other hand, have more time to weather potential market storms in exchange for increased growth potential, so they can afford to ballast their accounts more toward stocks.

Once you have a comfortable stock to bond ratio figured out, you should turn your attention toward making sure that you are properly diversified within these two classes of investments. There are varying opinions on what constitutes adequate diversification within an investment class, but in truth, there is no one size fits all scenario. It is again dependent upon your particular set of circumstances at this point in time.

When speaking of bonds, you want to have a selection of bonds that are divided between corporate bonds, mortgage bonds and government bonds. You also want to make sure that you have bonds with varying term lengths so that they mature at different rates. With respect to stocks, you want to choose small, mid and large cap stocks. You also want those choice stocks that cover varying industries.

There are two different ways in which you can achieve these levels of diversification. The first is to pick and choose the various investments yourself. Or, you can choose from a wide variety of stock and bond funds. But, buying these funds are not always the magic pill as many of the funds can be very industry specific. And with that comes a problem, if that industry is taking a huge hit in the financial markets, so will your investment.

The process of diversification can be confusing at best, and it is easy to take the wrong path. Start branching out. To begin receiving expert help with your investments connect with Cavalry Portfolio Services on Facebook.

Diversification never eliminates risk entirely. The best that you are hoping for is to minimize the impact of the risk while reaping the benefits of the return. In fact, having too many stocks in your portfolio can decrease your returns. The way that it happens is this: you make an investment in a stock and that stock does very well. If you only have 5 stocks in your portfolio, then you see a greater percentage of return. If you have 500 stocks in that portfolio then the return, and the impact of it, becomes negligible.

 

3 Responses to Why Diversifying Isn’t Always Necessary For High Stock Market Returns

  1. Great article. Diversification should be kept simple and understandable if someone objective were to look at your portfolio.
    I have always been a big fan of mutual funds that allow diversification between large medium and small funds in three categories of growth and value and blend. Build a tic-tac-toe board and set up these 9 possibilities. Add to this some international funds and some bond funds and you have an all weather portfolio. And by all means add in low cost index funds and make them your cornerstone investment.
    One final concern would be investing in bonds in our current low interest rate environment. If rates go up a lot, losses could be significant.
    Finally, assess your tolerance for risk. Many mutual funds, like Fidelity Investments, have a questionnaire that you complete to determine your investment nature in this regard.