In the investing world, diversification may be the closest thing to a mantra. Beginning investors learn early and often to diversify their investments, both across asset classes and among industries, and they are told that diversification lowers risk and can protect your nest egg from a collapse like the one we've just seen in the oil market. However, diversification can also be a siren's song for investors, supplanting better ideas and leading them into areas they'd be better off avoiding. Here are three reasons to keep your diversification in check.
1. Keep it simple
The more assets you own, the more work you have to do. As an individual investor, you should keep tabs on your holdings by following quarterly earnings reports and other major news items. Realistically, you only have so much time to devote to following your stocks. Probably, five or 10 is the most you can reasonably keep track of and sustain an interest in. Investors who get carried away and buy 100 different stocks will have trouble staying informed. Even on Wall Street, the average research analyst, who does this as a full-time job, only follows about 30 companies.
Instead of devoting your energy to diversification, focus on finding good investments and keeping an eye on them. Should conditions change to affect your thesis, you can sell and buy something else, limiting your holdings to a reasonable number.
2. You know what your best ideas are
The more investments you have, the more likely it is that you're mixing your best ideas with mediocre ones. Most investors have more expertise or understanding or in one area than others. If there's a certain industry you know well, you're probably better off investing in that area than blindly diversifying into businesses you don't understand.
Warren Buffett, the greatest investor in history, has shunned diversification specifically for that reason. He avoids tech stocks because he doesn't understand that industry, and has focused primarily on insurance, banking, and consumer goods companies, the areas he is most familiar with. Understanding those businesses and how to value them is what's made Buffett such a great investor. Knowing what to avoid has also helped, too. Bet on your best ideas, not on half-baked theories.
3. Let the good times roll
Diversification and its cousin, rebalancing, teach us to avoid risk even if it could cost us increased returns. Low risk and average returns seem to be the goal, but your best investments can often turn into multi-baggers, making up for mediocre returns in the rest of your portfolio. The worst you can do with a stock is lose the money you put in, so a portfolio with a few big winners and some losers will do a better than one with all stocks generating average returns. Big winners also often come from the same industry. The two best-performing stocks of the last 10 years were both beverage companies: Keurig Green Mountain and Monster Beverage.
Diversification and rebalancing limit risk, but they also tend to put a cap on returns. Depending on your investing goals, this can be very poor trade-off to make.
Better ways to safety
For the investor looking to limit risk in the stock market, buying an index fund is a better way to do it than hand-picking 100 different stocks, and it can help avoid fees that come with an advisor or a brokerage account. If you're looking for income, holding defensive, dividend-paying stocks like utilities and consumer staples is one solid strategy, and selling covered calls can also help. ProShares offers an ETF of the S&P 500 Dividend Aristocrats, which gives investors easy access to a group of stable companies that have raised their dividends for at least 25 consecutive years. Historically, dividend aristocrats have outperformed the broader market.
Diversification in and off itself isn't a bad strategy, but it's easy to get carried away. The goal of investing, after all, isn't a diversified portfolio; it's a growing one. To that end, concentrating on your strengths, keeping the number of investments manageable, and relying on dividends and index funds for security and income can often be better paths to that goal than diversification.
Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends Keurig Green Mountain and Monster Beverage. The Motley Fool owns shares of Monster Beverage. 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.