Let’s get right to it:
1. To diversify a portfolio is not to mitigate risk. This is one of the most popular misconceptions that exists on Wall Street. It is bought into by a vast majority of the public, as well as the vast majority of financial professionals. Diversification, instead of being a tool for mitigation of risk is actually a tool for transferring risk. By having a portfolio of 50 stocks, the resulting effect will be a closer correlation to the popular benchmarks. Saying that diversification is a tool for controlling risk is similar to saying that buying SPY is a method of controlling risk. It’s not. All an investor is doing is transferring the responsibility to manage portfolio risk to the market itself, which is no method of risk control at all.
2. Diversification increases an investor’s expenses when there are a multitude of ways to create the same effect. Wall Street institutions have created literally thousands of tools (ETFs) that create the same result as having a portfolio of 20, 40 or 100 separate names. Anytime you move over the 15 individual stocks mark in your portfolio, odds are that an ETF exists that will create the same effect for a fraction of the cost.
3. Diversification increases an investor’s propensity to become confused during periods of adversity and in fact, prosperity. By diversifying a portfolio an investor is not able to comfortably put together logical reasoning for the behavior of the portfolio at any given time. Instead, perhaps rightfully so, an investor begins to attribute performance to favorable market conditions, as opposed to any solid research that identifies favorable investment opportunities. During adverse periods, an investor will not be able to identify whatever leaks exist in the portfolio, with the exception of comparison to a benchmark as a means of assessment. Again, what is occurring here is that the portfolio is benchmarked to the point that all decisions are made relative to the benchmark itself. There is no separate structure to define risk outside of the benchmark, much less individual understanding of the investments in the portfolio.
4. Diversification increases an investors propensity to panic during periods of adversity. This is primarily as a result of complete confusion as to what is occurring outside of the popular averages. When a portfolio is diversified into 20 or more companies, what takes place during bear markets or even severe corrections is that individual pockets of strength in the portfolio will be overlooked, especially when panic sets in. It’s very logical that when a large number of companies that an investor doesn’t understand properly are all doing harm at the same time, that investor will be more prone to an illogical sense of panic at what is likely the worst time to do so. The lack of understanding that marks the essence of diversified investing is at the core of emotional decision making during adverse periods in the markets.
5. Diversification doesn’t allow a portfolio the potential to outperform over the long-term. Again, this goes back to the benchmarking effect that is at the root of a diversified portfolio. This correlation will never allow a portfolio to drastically outperform the market averages, whether during a bull market or bear market. What will instead occur is that the portfolio will, at best, have periods of outperformance that are highly susceptible to reverting to the mean and often times far below it once the market’s temperament shifts.
I am by no means a proponent of investors pouring everything into AAPL and GOOG at the first opportunity. Benchmarking a portfolio may be the correct strategy for some investors. However, there are better ways to do it than accumulate a collection of securities that even most professionals don’t understand properly. The ETF market has gone a long ways towards reducing the overhead an investor will face, as well as reducing the risk, not to mention the headaches, involved in making 40 separate decisions as to what to invest in, when to invest in it and how to manage it going forward.
Yeah, I know, it is not as fun to have one ETF where you can’t become a fanboy for the companies you own in a portfolio. At that point, one must ask themselves whether they are involved in the markets for entertainment purposes or wealth creation purposes? This isn’t meant to be fun, really. It’s a business just like processing potatoes or manufacturing rubber ducks is meant to be. If your primary goal is entertainment, then you’ll have your entertainment. Everybody gets what they want out of the markets, as one famous money manager once explained.
