Many great investors have commonly repeated this common saying. “Diversification is the only free lunch (in the world)”. Despite many investors preaching this truism and many of them practicing it by buying index ETFs or owning 30 to 40 stock portfolios, there is still a case against diversification. Warren Buffett, otherwise known as the Oracle of Omaha, has famously mentioned that “diversification is a protection against ignorance”. Wait, that is contradictory. This article will seek to explain the cases for and against diversification. Lastly, I will end off with how I practice diversification in my own portfolio.
Don’t put all your eggs in one basket
This is a common saying and I am sure if you have been in the finance community long enough, you would have heard this. We should not concentrate all our assets in one place because we risk losing it all if that particular sector falls.
Diversification helps you prevent that potential risk. If you buy into the stock of one single company, you are putting all your money into one single business. Any sort of bad news the company receives will inadvertently lead to a drop in your assets.
This has also been backed up by the Modern Portfolio Theory (MPT). MPT shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk. This usually results in a portfolio of at least 30 stocks. A quick and easy read would be Joel Greenblatt’s The Little Book That Still Beats the Market. It is based on the simple fundamentals of value investing.
Buy and forget
If you are not an investment banker, why would you spend so much of your time researching a stock? Unless you are willing to blindly put your money at risk and not spend any time trying to research the business, you will never have as much information as the professional investors who work on that for a living.
Diversification allows you to buy the whole market. It is better to buy the whole haystack than trying to pick out the needle from the haystack. How are you so sure that you have picked out the needle? Diversification allows you to buy and forget. You will not lose money because of your ignorance if you choose a good, low-cost, well-diversified index ETF.
Just by periodically checking you assets, you can enjoy your life while knowing that your assets are steadily growing.
Mitigate the cyclical nature of the market: Reduce risk and volatility
Like everything in life, the market is also seasonal. There is a cyclical aspect to the market. The market goes through booms and recessions. Right now, we are going through the latter. Through diversification and buying a broad-based index, you are mitigating the cyclical nature of the market.
For example, during the Summer season, sales of ice-cream and cold drinks would probably fare better than sale of hot soups and spicy foods. However, it is the opposite during the Winter season. Similarly, it works the same way for the market. If you buy the whole market, the losers will generally be propped up by the winners. In addition, if you believe in the long-term growth of an economy, the stock market will rise over time.
Through owning a large number of companies, volatility is also reduced if market sentiments change. Investors are humans and often, they invest with their emotions instead of facts. If there is a piece of bad news in a company, its share price would almost definitely fall. However, this volatility can be reduced if you are invested in other well-performing companies, which can mitigate this drop in value.
Diversification is a protection against ignorance. It limits the growth potential of a particular company. Let’s say you bought the Nasdaq Composite Index (QQQ). The main driving force behind the crazy bull run over the past few months would have been from the mega-cap tech stocks, namely the FANG companies. However, if you compare the growth of each company with QQQ, you will realise that QQQ does not have as great of a performance.
This is because the growth of QQQ is limited by other stocks which are part of the index. Therefore, the growth potential of the index is capped. There is almost no way you will see a Tesla kind of boom happening to an index. Basically, it is close to impossible for you to make an instant fortune out of the market, unlike what Hollywood movies suggest.
Not as exciting
Of course the limited volatility and the cap in the growth potential of your assets would lead to zero excitement. That is the bad part about passive index investing. It is boring. The strategy is simple, but it is not easy because not everyone is disciplined to buy and hold onto it.
Many people view the stock market as a way to fuel their gambling needs. However, when they realise that being diversified and passively invested into the market is the sure-fire way to earn money, they realise that it is not exciting as they initially thought it would be.
The trap of overdiversification
You might think that diversification is so good. So, you should invest in all companies. This will ensure that you are as diversified as possible. However, there is a trap of overdiversification. You can reduce unsystematic risk through diversification, but you cannot reduce systematic risk.
The MPT states that you achieve optimal risk at about your twentieth stock. As you add even more stock, you may just be disproportionately increasing your risk-reward ratio. Owning additional stocks takes away the potential of big gainers significantly impacting your bottom line.
For people who refuse to buy into an index ETF, they would want to buy individual stocks but accumulate enough of different stocks such that they remain diversified. However, to accomplish that without incurring excessive fees, you would need a sufficiently large capital.
Most brokers offer their services with minimum charges. Even though the NYSE and NASDAQ allows you to buy 1 share of a business, it doesn’t mean you should. Buying 1 share of a business often leads to very high fee percentages as compared to your investment amount. Thus, most beginner investors may lack sufficient capital to do so sensibly.
How I practice diversification
I buy index ETFs. But, I also buy individual stocks and S-REITs.
Currently, index ETFs take up about 50% of my portfolio. However, I aim for index ETFs to take up at least 70% of my portfolio. I DCA on my ETFs on a monthly basis.
I buy individual stocks because I still have the time and I am interested in researching businesses. In fact, it is quite interesting to see what the companies you see everyday consider their competition. It is fun to see the numbers and analyse their PE ratios, PB ratios, Net Incomes, Revenues. For REITS, you have gearing ratio, distribution per unit (DPU) and a lot more.
In conclusion, index ETFs are a very good way to practice diversification. Personally, I buy VT and QQQ. I DCA into VT on a regular basis and lump sum invest into QQQ when I see the opportunity is right. As for the other 30% of my portfolio, I pick good businesses which I like or I see have good growth potential. They are usually used as a riskier bet (US equities) or for dividends (S-REITs).