If there's one word that financial analysts, Wall Street gurus, and your local investment advisor tout, it's "diversification." The idea of buying assets in a variety of industries and equity classes, and presumably being able to take advantage of different economic and stock market events based on your variety of holdings, is believed to provide more stable, yet superior, long-term returns.
Broad-based diversification doesn't always make sense
However, not every financial magnate is a fan of the idea of diversification. Said the Oracle of Omaha, Warren Buffett, "Wide diversification is only required when investors do not understand what they're doing."
Meanwhile, bond-maven Bill Gross said, "Do you really like a particular stock? Put 10% or so of your portfolio on it. Make the idea count. Good investment ideas should not be diversified away into meaningless oblivion."
While putting your eggs in one basket is undeniably risky, and no one, myself included, would suggest any investor do so, broad-based diversification isn't always the answer, either. Here are four instances where broad diversification may not make sense.
1. If you're investing with a relatively small amount of money
To begin with, diversifying isn't always a great idea if you're working with a relatively small nest egg. What's a "relatively small nest egg?" Well, that's up to interpretation. For some folks that might be $250 or $500. For others, maybe it's $5,000 or even more. The issue is that commission costs and other possible activity fees could eat away at your nest egg if you purchase too many stocks or equities.
For example, if you have $1,000 and want to buy 10 stocks, the average brokerage firm might eat $7 to $10 in commission costs per purchase. That's 7% to 10% of your nest egg that you'd be handing over just to own $90 to $93 worth of 10 different stocks. While that might pay off over the long run, you're probably better off buying one or two stocks with your $1,000, and adding new capital (as well as new stocks) as your portfolio grows and ages.
2. If you'd have to dip into margin in order to diversify
Probably the clearest no-no on this list is if you'd have to use margin, or money borrowed from your brokerage firm, in order to diversify your portfolio. Depending on the brokerage firm, borrowing capacity on cash typically ranges from one to three times the value. Therefore, hypothetically speaking, $1,000 in cash could allow an investor to borrow an additional $1,000 to $3,000 in margin.
Using our previous example, an investor with $1,000 in cash could suddenly buy up to $4,000 worth of stock, which would include $3,000 in margin. Though it would appear to represent a considerably smaller commission cost as a percentage of total investments, it would still cost this investor 7% to 10% of their cash holdings.
What's more dangerous is that margin interest rates are typically high, and a hawkish Federal Reserve has them on the rise. In an attempt to diversify, this investor might be paying anywhere from 8% to 10% per year on the borrowed money. Plus, the use of margin increases portfolio leverage and risk, which is the opposite of what diversification typically does. A small move lower in the stock market could wreak havoc on a highly levered portfolio.
Long story short, diversifying with margin isn't a good idea.
3. If you're struggling to keep up with the headlines of what you already own
Another reason not to overdo it with diversification is that it could make following your existing holdings more difficult.
In a perfect world, you own a reasonably diversified portfolio of assets, and you're able to make the time each day, week, or month, to review your investment holdings and ensure that your investment thesis -- the reason(s) you purchased a stock or equity in the first place -- still hold(s) true. Again, the number of stocks in a "reasonably diversified portfolio" is entirely up to interpretation, and it could mean a handful of stocks, or perhaps dozens of stocks, depending on your willingness to be actively involved in company or equity research.
When diversification becomes a problem is when you're no longer able to keep up with all of the assets you own. If you find that you don't have the time or energy to keep up with the major headlines of your existing holdings, then adding even more assets to your portfolio probably isn't a good idea.
4. If it reduces the quality of your investment holdings
Lastly, and to echo Bill Gross's quote from earlier, it's often a poor choice to force diversification on a portfolio if it takes away from what you believe could be a great investment opportunity.
To use a personal example, between 2012 and 2014, I actively purchased shares of a Canadian gold-mining company known as Claude Resources. I'm a bit of a nibbler when it comes to investing, so I added to my position on 26 separate occasions over about a two-year span, averaging down in the process as Claude was busy handling a restructuring of its debt. Though it easily made up the largest position in my portfolio, it wasn't extraordinarily large.
However, in 2016 that changed. A rally in spot gold prices, along with a nearly all-share buyout from SSR Mining (TSX:SSRM) that had a hefty premium attached, sent Claude Resources through the roof. Now, over two years following the completion of the buyout, I've still not sold a single share. For between four and six years I've held my investment, which is now in SSR Mining, and over that span, the investment has increased in value many times over. It's to the point where it makes up a very large percentage of my invested portfolio, despite my regularly holding between eight and 12 stocks.
And yet, I won't diversify by selling down my stake. Why? Because I believe SSR Mining is a great investment opportunity. It's one of the cheapest mining companies based on future cash flow per share, it has a low all-in sustaining cost for gold production, and it's about to bring new silver production online in Argentina. Since my investment thesis hasn't changed, neither has my need for additional diversification.
In sum, while minimizing risk through diversification can often be smart, it's not always a good idea.