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.
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.
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To your Health, Wealth, and Freedom!