As you may know, I believe that developing a wealth mindset and understanding the metaphysical laws of money and abundance are the essential elements of creating Financial Independence.
However, being savvy about managing and investing your money is another essential aspect of creating Financial Independence.
If you don’t save and don’t invest your money strategically, no matter how much you may be earning right now, it’s unlikely that you’ll enjoy financial independence or have a comfortable early retirement.
Unfortunately, many women are afraid of investing because they are afraid to lose money…
And when they hear confusing advise (like “You should diversify!” and “NO! Don’t diversify!”) – they resign to doing nothing (and lose time and opportunities) OR choose to delegate managing their money to advisors, spouses, or partners…and often lose even more money.
That’s why, today, I chose to share this short video with you.
Now, I have a question for you.
What would your life be like if you could do what you want, buy what you want, have the amazing experiences you want…without worrying about money?
And if you’re ready to trade worries about money for complete freedom, why not get started now?
I’ve opened up a few slots for my PRIVATE Complimentary “Financial Freedom Lifestyle” sessions, where you can see your worry-free future unfolding in front of you.
Sound exciting?
Great!
Send me an email to Millen@DareToChangeLife.com with the subject line Financial Freedom Lifestyle, describe your current situation, financial goals and timeframes, and your level of commitment to your goals (on a scale of 1-10).
When it comes to diversification, some beginner investors get confused about the degree of diversification they need to maintain in their investment portfolios. After all, there are SO many choices out there!
And while diversification is a smart risk management strategy (and I talked about its benefits at length in the PART 1 of this Wealth-building mini-class series), this strategy must be approached wisely.
There is an old saying: “Everything has a front and a back.”
I find it true.
So, today I want to share with you the “back” of diversification, which is Over-diversification so that you’ll be aware of what NOT to do.
Over-diversification is a common mistake that can significantly decrease the returns from your investments compared to the risk of losses in your portfolio that you mitigate with the diversification strategy.
Because most investors are aware of the harmful effects of under-diversification, many mistakenly believe that the more diversification the better. This concept is false and can lead to significantly diminished returns in your investment portfolio.
It’s like getting natural vitamin D from the sun because it’s essential for your optimal health, however, receiving over-dose of the sun radiation through the extended exposure can lead to serious health issues.
How the Over-diversification happens?
Over-diversification happens when the number of investments in your portfolio exceeds the level where the loss of the expected return from your investments is greater than the benefit of reduced risk from the diversification.
When you add investments to your portfolio, it lowers your risk of loss but potentially lowers the expected return as well.
For example: Let’s say, you own 1 stock instead of 1000 stocks. If you own just one well-performing stock, your expected return (gain from investing in this stock) is very high but so is your risk. Your entire portfolio performance will depend on that one stock.
In Part One of this mini-class, I shared with you my story when I invested all retirement funds into the stock of the company I worked for at that time. This portfolio performed fabulous… until the stock market crashed.
SO, you I hope by now you clearly see the benefits of going from one stock to five, or from five stocks to twenty.
Each time you add a new investment to your portfolio, it will lower your risk of experiencing devastating losses. However, after a certain point, it will also lower the expected return from your investment portfolio.
For example, if you own 1000 stocks, you will eliminate unsystematic risk (risk associate with a particular company or industry), but, most likely, your portfolio will not contain the best performing stocks and the highest quality companies.
I pretty much can guarantee that a portfolio of 1000 stocks, whether owned individually or through Mutual Funds or ETFs (Exchange Traded Funds), will contain a wide range of opportunities – from best to worst. There will be some great picks (companies with phenomenal performance and growth potential) and quite a few losers.
In other words, at some point in your diversification efforts, you can reach the number of investments where the benefit of risk reduction is smaller than the decrease in expected gains.
How to Decide on the Optimal Diversification
What I want to bring to your attention today is that owning only 15-20 great stocks in your portfolio, which are diversified among a variety of industries, would be a much better choice than owning 20 great stocks plus 980 mediocre or poor performing stocks because these 980 will pull down your portfolio’s performance.
That’s why over-diversification leads to below average or even poor returns in your portfolio. And you may fall into this “over-diversification” trap by simply holding a few mutual funds, ETFs, and index funds that are over-diversified and focus on quantity instead of quality.
How to Diversify Your Portfolio
I strongly believe that diversification is not simply a numbers’ game.
As I demonstrated earlier, the number of investments in your portfolio does NOT determine how risk-prudent and performance-optimized your portfolio is.
The trick to successfully diversifying your portfolio is owning investments that play different roles in your investment portfolio.
Just like having a team in your business where every team member has a specific role in order to achieve best possible results in your business, your investments need to have different roles in order to achieve best returns in your investment portfolio.
Some investments meant to focus on Growth, others on Income, and yet others on Value (good companies that are going through transition and are currently undervalued).
You can also diversify your investments by companies’ market capitalizations (small-, mid- and large- caps). And you can choose to own domestic and international companies from different market sectors.
But to really optimize your investment portfolio, I invite you to consider adding alternative investments into the mix like real estate or commodities. Because, historically, alternative investments’ performance doesn’t highly correlate with traditional assets like stocks and bonds.
When stocks and bonds are moving straight up or straight down, alternatives can move diagonally. It’s like taking the escalator instead of the elevator to your financial goals. With alternative investments in your portfolio, you may be moving a bit slower toward your financial goals but you’re less likely to get trapped between floors.
The Bottom Line
We talked a lot about the importance of diversification in the Part 1 of this mini-class series. However, you’ve got to be aware of the dangers of Over-diversifying your portfolio.
The optimal diversification of your portfolio would be to own a number of individual investments that are large enough to almost eliminate unsystematic risk but small enough to focus on the best-performing opportunities in the long term.
For more resources on various financial topics, check this page on my website:
I recently received a promotional email from Robert Kiyosaki, the famous author of the “Rich Dad, Poor Dad” and a legendary Real Estate Investor. The Headline of his sales page brought my attention (and, of course, that was the goal). It was screaming about bad advice – to diversify investments – that people get from licensed financial professionals.
Here’s what I recall reading in his promotional email: “Many financial advisors recommend that you diversify for your own protection. What they fail to tell you is that it is also for their protection. Since most financial advisors cannot tell you exactly which stock or mutual fund is a great investment, they tell you to buy a bunch of them.”
And there was also a quote from the legendary investor Warren Buffett: “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
I must say that for a split second I was thinking like “What the heck?”
And while I have great respect for both gentlemen – Robert Kiyosaki and Warren Buffett – I also KNOW that both of them indeed DIVERSIFY their investments among different asset classes.
For instance, Robert Kiyosaki invests in Real Estate but also in the stock market and precious metals, to name a few.
And Warren Buffett invests in the shares of companies of different sizes and from a wide variety of different industries (he is a great Value Investor).
So, I decided to clarify any confusion that you may feel about the pros and cons of Diversification.
Let’s begin with a definition of the DIVERSIFICATION as it pertains to your investment portfolio.
In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.
In other words, the objective of diversification is to reduce the risk to your investment portfolio from the catastrophic loss of any single asset that it contains.
And if you want to invest, you must deal with the ups and downs of financial markets because ALL financial markets go through up-down cycles and you want your portfolio to survive and grow over a longer period of time. That’s why having an investment strategy matters when it comes to investing in any financial market.
From my personal experience (losing over 50% of my retirement funds that were invested in the stock of the company I used to work for) and by studying and observing some of the most successful investors in the U.S., I KNOW that if you want to protect yourself from a market downturn, you must diversify.
In this article, I want to look closer at the benefits of the diversification.
THREE BENEFITS OF DIVERSIFICATION
1. Risk Reduction.
ANY investment involves risk and you can never eliminate risk completely. However, you can certainly manage your level of risk.
Beginner investors must embrace risk because the potential long-term rewards make it worthwhile. It’s always about evaluating the risk/reward ratio: Your level of risk must correspond to the level of potential rewards.
When you begin investing in your early 30s or 40s, you can afford taking higher risk because your investment portfolio has enough time to recover should the financial markets hit the downturn. For example, an investment that declines in value by 50% must appreciate by 100% to recoup its original value. That takes time!
In your late 50s or 60s, when you get closer to your retirement phase in life, you must be more mindful about taking high risk with your investments because you don’t want to experience devastating losses in your retirement portfolios during the economic downturn and you may not have enough time to recover from losses.
Diversifying your portfolio among different assets that don’t perform in a similar fashion during economic downturn (e.g. gold and tech stocks) allows you to reduce risk of losses from each particular asset.
Many investors who failed to diversify among different asset classes during the economic downturn in the U.S. in 2008-2009, got themselves highly exposed to the stock market risk.
Diversifying into safer fixed income assets and precious metals, as well as using capital preservation strategy can help reduce the risk in your investment portfolio.
Capital Preservation.
If you paid attention, I mentioned capital preservation strategy in my previous point. And here’s the truth: some investors strive for capital appreciation, while others use capital preservation as an investment strategy.
Capital preservation allows you to protect the capital you have, instead of focusing primarily on the rate of return on your investments.
Diversification makes it easier for you to protect your capital, allocating money to different investments.
Investing in a variety of assets reduces risk, especially comparing to investing in a limited number of stocks in the same industry (e.g. technology or bank stocks).
You do not have to worry about some bad apples like Lehman Brothers stock (which I used to own) crushing your retirement portfolio if you lessen the impact that these “poorly performing” stocks have on your portfolio by diversifying your investments. Like I said, even though I lost a bit of money while investing in the Lehman Brothers, it was a drop for my portfolio and a lesson learned.
In addition to risk reduction and capital preservation, you can also hedge your portfolio when you use diversification as your investment strategy and risk management.
Hedging Your Portfolio.
Using diversification strategy can help grow your portfolio during bull markets (when markets boom) and bear markets (when markets turn downward).
Investors who have had 100% equity portfolios (had 100% stock assets in their portfolio) over the past 10 years, have seen relatively poor to average returns.
If they diversified their portfolios by including asset classes like precious metals, commodities, and bonds, they would likely have experienced higher returns.
In other words, diversification allows investors to achieve positive returns in some asset classes (e.g. precious metals) when other asset classes (e.g. equity) are generating negative returns.
The Bottom Line
Diversification offers a number of benefits to investors. It is appropriate for passive investors (those who don’t invest full time), for risk averse investors (those who have a very low risk tolerance) and for prudent strategic investors.
It has been my experience (after investing in the stock market for over 25 years) that diversification helps protect your capital from market volatility, while at the same time allows you to achieve long-term growth in your investment portfolio.
However, diversification has its drawbacks as well (remember, everything has a front and the back).
I’ll share with you the potential downsides of diversification next week.
For more resources on various financial topics, check this page on my website:
