FP Article 15.5
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Investment Risk -
Diversification Risk
by Rajen Devadason
Wide diversification is only required when
investors do not understand what they are doing.
Warren Buffett
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|
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 |
|
|
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
