It is common investment advice to diversify your investment portfolio. Why should you consider doing this and why might you want to ignore such advice? There are good arguments for either approach. Here are some thoughts on the subject.
What Is Portfolio Diversification?
When one diversifies their investments, they avoid owning just one stock, investments in just one stock sector, one property or set of properties in a single location, investment in just bonds or one set of bonds, or investments solely in one county. The point of diversification is said to be reduction of risk, especially when it comes to just investing in one stock. As an example, when interest rates go up the economy as a whole may suffer and many stocks will fall in value. However, banks will improve their profit margins and their stocks will rise in value. Thus, an argument for having a bank stock along with a mix of industrials, real estate-related stock, etc. is that the rising bank stock will offset losses from your other stocks. Another example is to have consumer or health stocks in your portfolio because people keep buying groceries or medicines even during a recession. Thus such stocks retain their value while others fall in price due to a recession.
Does Diversification Increase Your Odds of Growing Your Investments?
Another argument for diversification is simply that by adding more stocks or other investments to your portfolio you will increase the chances of having a big winner. This argument assumes that you are making wise choices in your investing as it is equally or even more possible that you will end up making poor stock picks and be simply adding more losers to your portfolio.
What an Investment Expert Says About Diversification
Warren Buffett is a famous and prosperous investor who at one time was the richest man in the world. His approach to investing is that you need to understand what a company does to make money and assure yourself that their business plan, products and/or services, management are such that they are likely to make good money into the future. Thus, he looks for what is called intrinsic value in a stock. What he once said about diversification is that it is “protection against ignorance” and “it makes no sense if you know what you are going.” This goes along with our opinion that you need to choose investments wisely as you diversify. This approach makes sense for Mr. Buffett but does it make sense for you?
What Does an Average Investor Do About Diversification?
We believe that Mr. Buffett’s comment makes sense if you are a professional investor who has devoted their life to choosing wise investments and has the time and energy to follow both the general market and individual stocks. As a practical matter most mom and pop investors have some money to invest with the hope of building a nest egg. They do not have time to develop the necessary expertise or the time and energy to devote to making the best investment decisions. Another piece of advice from Buffet is pertinent in this regard. He says that most folks should simply put their money into an exchange traded fund that tracks the S&P 500. This is an index that follows the biggest 500 companies. The S&P 500 has, in fact, doubled in the last five years as the big tech leaders of the market have soared. The S&P 500 has a huge degree of diversification and does not require that you pick individual stocks. This, in our mind, is the best path to diversification for the bulk of mom and pop investors who have their own lives, jobs, and issues to deal with and also have money to invest.
S&P 500 Last Five Years
How to Invest Most Efficiently
If you are going to put money into an ETF that tracks the S&P 500 we suggest that you use dollar cost averaging. With this approach you do not try to time the market. Rather you put the same amount into you account every payday, month, quarter, etc. This way you avoid buying excessively when share are overly expensive and tend to buy at bargain prices when the market falls.