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FP Article 15.5 (To sign up for a FREE 16-lesson eCourse on Investment Risk, please click here.)

Investment Risk - Diversification Risk

by Rajen Devadason

Wide diversification is only required when investors do not understand what they are doing.

Warren Buffett

  I believe in the importance and the power of diversification.

In fact, many years ago when I first set up my financial planning practice, I did so on basis of three foundational principles:

1. Delayed gratification;
2. Diversification; and
3. Buying low and selling high.

As you can see from the inclusion of diversification, I consider it a great thing to aim for in any portfolio.

 

 

 

 

 

 

 



Nonetheless, there is a downside to diversification. That 'negative' is predictably called diversification risk.

Diversification risk arises from a shift away from moderation to one of two extremes!

This is an article explaining diversification risk. I hope you enjoy reading it. But if it isn't what you're looking for, you're welcome to search for something that better meets your needs. Thank you for allowing me to serve you.

Rajen Devadason

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First, if you have too little diversification in your portfolio, you run the risk of having excessive exposure to the vagaries of a single investment. Another way you might have too little diversification, even if you have lots of different investments in your portfolio, is to have too much of the same kind of investments.

For instance, if you have a stock portfolio that has 30 counters in it you might think you've got loads of diversification. But what if 28 out of those 30 companies are all in the same sector, let's say plantations.

Can you imagine the hammering your total portfolio will have to endure if the prices of what your companies grow and sell - be it rubber, palm oil, coconuts, whatever - were to nosedive? Key lesson:

Excessive volatility is the end result of under diversification.

Second, at the other extreme, too much diversification means your portfolio is likely to never really do exceptionally well. You see, by spreading your investments across too many different areas, your overall portfolio performance will end up doing no better than average.

That's because what will then tend to happen is the gains you enjoy from your star performers will be swamped by the losses caused by the 'dogs' in your portfolio 'kennel'.

The technical term for this is quite frightening - your portfolio's performance will regress to the mean of your benchmark index! Translation:

Mediocrity is the end result of over diversification.

Numerous investment science-related studies generally have shown time and again that if you want to avoid suffering under diversification, you should aim to have more than 8 rather different investments in your portfolio. If you want to avoid being over diversified, don't have more than 30 different investments.

If you'd like to continue to learn more about other types of investment risk, here's additional information for you...

15 Types of Investment Risk (OR, to sign up for a FREE 16-lesson eCourse on Investment Risk, please click here.)

1. Borrowing Risk

2. Company Risk

3. Credit Risk

4. Currency Risk

5. Diversification Risk

6. Industry Risk

7. Inflation Risk

8. Interest Rate Risk

9. Liquidity Risk

10. Lost Opportunity Risk

11. Manager's Risk

12. Market Risk

13. Market Timing Risk

14. Political Risk

15. Prepayment Risk

 

 

© Rajen Devadason

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   Useful Resources
  
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Who is Rajen Devadason?
Author, consultant and speaker.
Learn about him here.
 

 

 

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Rajen Devadason, CEO RD WealthCreation Sdn Bhd & RD Book Projects
349, Desa Rasah, Jalan Bayan 7, 70300 Seremban, NS, Malaysia
Tel/Fax: +606 632 8955

 
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