Is it possible to “diworsify,” actually diversifying to the detriment of portfolio health? Believe it or not, the answer is yes! It is common knowledge that diversification is needed within a portfolio to eliminate some of the risks associated with investing. However, if this is not done properly, you could be kissing any meaningful gains goodbye. Don’t be frightened; we are not suggesting that you calculate the variances, covariances, and coefficients of variation between every stock held in your portfolio. This takes far too much time, and Research Analysts might not have a job. What we suggest is that an investor either executes the necessary due diligence or employ someone to do it.
Part of the problem is that there is no magic formula for diversifying investment holdings. Another part is many investors do not understand the concept of diversification. That is an easy one to fix.
Many investors equate diversification with holding a large number of stocks. This is wrong. A portfolio can be well diversified with as few as eight to 10 stocks. Of course, properly diversifying with a small number of stocks involves some mathematical gymnastics, which we will not attempt to explain today. True diversification involves spreading investments over a variety of industries and instruments (stocks, bonds, mutual funds) to reduce the volatility in the portfolio’s valuation. It is important to note that when selecting stocks in a portfolio, it is important not to concentrate on one particular industry. When too large a percentage of a portfolio’s holdings is dedicated to a particular industry or stock, you have made the first step toward “diworsifying.” Also, watch those funds! In many cases, investors hold stocks outright, and their mutual funds also hold a sizeable position as well. This is not a good thing, as it can lend too much weight to certain stocks in the portfolio.
Diversification is necessary to reduce risks and ramp up returns, but incorrect or excessive diversification is about as useful as not diversifying at all. An understanding of the economic climate and how that climate affects the movement of stock prices is essential, as is a basic understanding of industry trends and market psychology. There is one more thing you need: time, and lots of it. If adequate time is not taken for “due diligence,” egregious errors in stock selection could be made. It might sound like overkill, but when researching a potential addition to a portfolio, you must take care to leave no stone unturned in making prudent stock choices.
One of the easiest ways to diversify is to work from a benchmark like the S&P 500 Index. Study the composition of the index: how the stocks, industries and sectors are weighted. From there, consider what the best mix for your portfolio might be. You may wish to overweight some sectors, holding a higher total percentage of these stocks than the index contains, because you think these sectors will outperform, while underweighting sectors that you think will lag. Sometimes, certain sectors will make up so small a percentage of the benchmark that you may choose to ignore them altogether. This is one of the allocation games. It works well in many cases because there is already a predetermined guide. Do not feel bound to the S&P 500 though, as there are others, such as the Dow Jones Industrial Average or Russell 2000 that might fit your objectives better. Once you have determined how to weight your portfolio, search the top performers going forward. You should be able to stave off “diworsification” as long as fundamentals remain intact.
At Henssler Financial we believe you should Live Ready. That includes doing your research when designing and assembling a portfolio. The best approach is to find winners and stick with them. Using this method, you should have less chance that you will lose a dime to make a nickel. If you have questions about your portfolio, contact our experts at 770-429-9166 or experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
