Nary does a day go by without someone in the financial media pushing diversification. Whether it's in print, on TV, or on the radio, the phrase "diversification is good" is trumpeted in times of both market turmoil and exuberance.
But while diversification may be good for some portfolios, it could be exactly wrong for others. The trick is to learn how to properly diversify for your situation and tolerance to risk. In truth, avoiding an oversimplified approach to spreading investments thinly and embracing a lopsided portfolio gives investors a better chance to soundly beat the market.
The good and the bad
Before I get hammered on the assumption that I'm poo-pooing diversification, let me be clear: I'm not. For someone retired and pulling income off their investments, diversification is a good idea. But for the investor who is looking to blow away the market, consistent diversification is the best way to guarantee mediocre performance. To maximize long-term returns, investors should be concentrating funds in the stock of great companies that continue to prove their mettle.
One of the biggest diversification mistakes investors make is cutting back on their winners that grow to a large portion of their portfolio. What many investors call "rebalancing" can actually take money out of your best stocks and spread it in more mediocre places. Not good.
To illustrate, look at several stocks that have been widely held winners in the past few years:
|
Company |
Five-year gain |
|---|---|
|
Apple Computer (NASDAQ:AAPL) |
773% |
|
Garmin (NASDAQ:GRMN) |
488% |
|
Research In Motion (NASDAQ:RIMM) |
1,153% |
|
J2 Global (NASDAQ:JCOM) |
2,977% |
|
Celgene (NASDAQ:CELG) |
485% |
What if you'd sold half of a position in Garmin a few years back to diversify into a Treasury bond? You would have gone soft before another double in Garmin's stock. Or how about selling most of your J2 Global stake after a year because it grew so fast it constituted a majority of your portfolio? You would have missed out on another five-bagger.
Gut check
In reality, spreading money thinner is often done to make us feel better -- it protects a portfolio from short-term, stomach-churning drops in value that may shake an investor's confidence. For instance, Starbucks (NASDAQ:SBUX) took a nasty 50% dive in two months in 1998. Ditto with a 60% drop in Quality Systems (NASDAQ:QSII) in 2000. Widely diversified investors may not have even known these events happened as their portfolio values hardly budged from the dips.
But the kicker is that Starbucks is up more than 700% since that dramatic drop. And Quality Systems has gone up more than 20 times in value. Investors who were shaken into selling may have felt good in dodging a bullet by diversifying, but they paid the price in terms of performance. Poorer performance.
Know where you stand
Hands down, the best and fastest way to grow your money is to have it invested in the stock of the absolute best of public companies -- those with top management, growing sales, and large potential markets. Tom and David Gardner look for these very companies in their Motley Fool Stock Advisor service. To get a glimpse of the leading stocks Tom and David think will outperform the market, click here for a 30-day free trial to the service.
Fool contributor Dave Mock enjoys the diversity of Mac n' Cheese -- so many choices of noodles. He owns shares of Quality Systems, Garmin, and Starbucks. A longtime Fool, he is also the author of The Qualcomm Equation . Starbucks, Garmin, and Quality Systems are Stock Advisor picks. The Fool has a disclosure policy.
