Market Pulse: Diversification is overrated
June 12, 2013
"Diversification" is buzz word in the financial industry. Many advisors say they run diversified portfolios and generic computer models at most discount brokers automatically build diversified portfolios for clients. They ease client fears by saying, "don't worry, you're diversified."
Unfortunately, diversification is overrated.
The theory behind diversification is that investors who hold a lot of securities that don't move in lock-step are protected because in bad times some of the holdings zig while others zag.
The problem comes in when the securities move independently of each other in bull markets, but not during bad times. In effect, you are diversified when you don't need to be, but not when you do.
“Diversification is protection against ignorance. It makes little sense for those who know what they’re doing.”
Just simply look at 2007-08, the last market drop, to see how diversification failed to work. It didn't matter if you held large-cap stocks, small-cap stocks, gold, junk bonds, etc. They moved independently on the way up, but during sell-off they all fell together.
Another reason I'm not a fan is that diversification forces you to buy bad investments. Those who run diversified portfolios periodically rebalance, buying more of investments that have fallen and taking profits from investments that have gone up.
Readers of this column know I'm no fan of Treasury bonds, but those running diversified portfolios would not only hold them, they would be buying more when they rebalance. If an investment has a poor outlook and bad fundamentals, I won't own it.
If your monthly brokerage statement resembles a book rather than a concise listing of holdings, then you are probably over diversified. Most of my clients hold 10-15 securities.
Even my largest accounts hold around 20. That's enough. Attractive securities are overweighted and unattractive ones aren't held.
Investors read that diversification is a must. No it's not. Being concentrated in a handful of stocks and seeing what others do (and being right about it) is the best course.
David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.