The Advantages and Disadvantages of a Diversified Portfolio

You could lose less. You could make less.

Jan 7, 2016 at 7:08AM

Along with every investment comes not only opportunity for gains, but also risks. A few major ones are:

  • The risk of losing money.

  • With price volatility, your investment may not be available at a value that's acceptable to you when you need it.

  • The emotional toll that the fear of losing money and volatility can take -- and the possibility that fear or exuberance could cause you to sell or buy at the wrong time

Wherever a particular investment or group of investments is subject to the same possible negative event, you can diversify away from that group of investments to minimize that risk.

Here are a few examples of different kinds of diversification and how they can reduce risk.

Position-level:

Suppose you invested your entire life savings into Domino's Pizza stock. If the company were to be bankrupted by an accounting scandal, driven into the ground by competitors, or simply fail to grow at the rate investors expect and demand, you'd be out of luck.

You could limit the potential damage of risks specific to a single investment by choosing multiple investments.

Industry:

Suppose instead that you invested all of your money in Domino's, Papa John's, and Yum! Brands (proud corporate owner of Pizza Hut). Now you'd be better protected from risks to Domino's, but you'd still be vulnerable to risks to the pizza industry. Maybe fierce pizza competition will force each of your companies to become less profitable; maybe health-conscious customers will gradually move away from pizza; maybe less rainfall permanently increases the costs of meat and cheese. To avoid such industry-specific risks, you can invest in multiple industries.

It's not always clear when you don't have diversification across different kinds of businesses. You might own pizza, soda, jewelry, cosmetic, and clothing stocks. Even though these are different industries, they're all consumer-based. An event that reduces consumer spending could affect all of them.

Company size:

Stocks of certain sized companies can perform differently from other sized companies over fairly long periods of time. So many investors allocate some money to groups of small (say, $300 million to $2 billion in market cap), medium-sized ($2 billion to $10 billion), and large ($10 billion and up) each.

Geographic:

Economic downturns, currency fluctuations, political instability are all risks that can affect a single country. Many investors try to spread their investments across different countries and regions.

Style:

Certain strategies -- whether value, growth, or dividend investing -- can be more successful than others over periods of time.

Asset type:

Finally, different kinds of assets can have different return characteristics based on factors like economic activity, interest rates, inflation, or their relative valuations. Bonds, for example, tend to be less volatile than stocks, which makes them popular with retirees who may not have the option of waiting out a drawn-out stock market decline.

For these reasons, many investors try to spread their investments between stocks, bonds, real estate, (and sometimes even commodities).

Disadvantages of diversification
Some amount of diversification is pretty much universally advised to reduce the risks of losing money, volatility, and emotional stress. But just as diversification can limit your downside by averaging out risk and volatility across a group of investments, it can also limit your upside. As your level of diversification increases, your returns will be more likely to mimic the market average.

It's also possible for diversification to increase your risk if it leads you to purchase investments that are risky or that you don't understand very well. For example, an investor who lacks exposure to pharmaceutical companies, gold miners, hedge funds, or emerging market economies and knows nothing about these (risky) fields, might make a mistake by investing in them purely for the sake of diversification.

A highly diversified portfolio can also be more time-consuming to manage than a less-diversified portfolio because you'll have more investments to follow and trade, plus more layers of diversification to make sure you're adhering to. Transaction costs could also be higher if maintaining your diversification requires you to micromanage and trade more frequently.

Finally, while diversification can reduce risk, volatility, and heartburn better than non-diversification, it doesn't always work as well as hoped. During the 2008-2009 financial crisis, for instance, pretty much every stock fell substantially, and asset classes that had historically performed differently from each other moved in tandem. The relative inefficacy of diversification during financial crises can come as a shock.

The key is to find the right level of diversification for you.

Ways (and how much) to diversify
For people who invest in individual stocks, 20 or so well-diversified names can be enough to provide enough diversification without becoming a managerial hassle or diluting your returns.

You can achieve even broader diversification without picking your own stocks or bonds by investing in index funds, exchange-traded funds, or actively managed mutual funds.

As far as asset allocation goes, a simple 60-40 stock-bond mix is an appropriate choice for many people.

The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

The Motley Fool owns shares of Papa John's International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Money to your ears - A great FREE investing resource for you

The best way to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as “binge-worthy finance.”

Feb 1, 2016 at 5:03PM

Whether we're in the midst of earnings season or riding out the market's lulls, you want to know the best strategies for your money.

And you'll want to go beyond the hype of screaming TV personalities, fear-mongering ads, and "analysis" from people who might have your email address ... but no track record of success.

In short, you want a voice of reason you can count on.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich," rated The Motley Fool as the #1 place online to get smarter about investing.

And one of the easiest, most enjoyable, most valuable ways to get your regular dose of market and money insights is our suite of free podcasts ... what we like to think of as "binge-worthy finance."

Whether you make it part of your daily commute or you save up and listen to a handful of episodes for your 50-mile bike rides or long soaks in a bubble bath (or both!), the podcasts make sense of your money.

And unlike so many who want to make the subjects of personal finance and investing complicated and scary, our podcasts are clear, insightful, and (yes, it's true) fun.

Our free suite of podcasts

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. The show is also heard weekly on dozens of radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable. Rule Breaker Investing and Answers are timeless, so it's worth going back to and listening from the very start; the other three are focused more on today's events, so listen to the most recent first.

All are available for free at www.fool.com/podcasts.

If you're looking for a friendly voice ... with great advice on how to make the most of your money ... from a business with a lengthy track record of success ... in clear, compelling language ... I encourage you to give a listen to our free podcasts.

Head to www.fool.com/podcasts, give them a spin, and you can subscribe there (at iTunes, Stitcher, or our other partners) if you want to receive them regularly.

It's money to your ears.

 


Compare Brokers