The Reality of Diversification

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

The typical investor is being constantly bombarded by the media and financial advisors shouting diversify, diversify, diversify. So what does the average investor do? They end up buying more stocks or mutual funds just to make sure they are diversified enough. Over-diversification of stocks actually decreases your returns by hindering the effect of your great performing stocks.

Typical diversification that is recommended by financial advisors might include investing different percentages in the following: large cap stocks, small cap stocks, international stocks, fixed income and cash equivalents. Would you consider this wide diversification? I sure would. That makes me really think about the advice that financial advisors are giving.

When should investors really should diversify for their protection? First, is when they are passive investors who uses a buy and hold investment strategy that includes holding for 10 years or more. In this situation wide diversification in different industries or sectors can protect you from one industry collapsing and adversely affecting your portfolio such as the late 90's tech bubble busting.

The second reason why someone should diversify is if your buying riskier stocks in hopes of large returns. If you are investing in stocks that are more volatile and are risky it can be wise to buy a more diverse group of them in hopes of finding a couple that take off like a rocket and produce the significant part of your return.

In summary, wide diversification can be very useful in certain investment scenarios such as a long-term buy and hold, but seems to be misunderstood and overused by many.

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