3 Reasons Why You Need to Have a Diversified Portfolio
While having a diversified portfolio of multiple stocks and other asset classes isn’t as exciting as betting everything on a few stocks, you should think twice before putting all of your eggs in one basket. The only way to get truly superior performance is to hold concentrated positions; but what many don’t understand is that they have to pay a price for their neglect of risk. Here are three reasons you should stick with a diversified portfolio instead of investing in concentrated positions:
A diversified portfolio will allow you to earn similar returns to concentrated investors with much less risk
Let’s say you have a million dollars and you are looking to buy a restaurant. If you tried to buy one million dollars of stock in a public restaurant chain such as Darden (think Capital Grill, Olive Garden, Red Lobster, etc.), you probably wouldn’t be able to buy buy it at a price that yielded anymore than 8% return on equity over time. Can you see a problem with this? If Darden is the only stock you own, shouldn’t you want more than just 8% return to compensate you for taking on the risk that Darden might perform poorly compared to other stocks? Now let’s say instead you decide to invest the million dollars in a diversified portfolio of stocks. You will get the average return of all of the stocks in your portfolio, and if 3 out of 50 stocks have bad years, you wont care because 3 of your stocks probably had great years!
When you invested in just Darden you had two things to worry about. If the market goes down as a whole, you will lose money (this is something you can’t avoid unless you are a stock oracle). You could also lose a lot of money if the company itself has an issue. Why would you accept the extra risk of the company having a fundamental problem if you could earn the same return without taking on that risk? That’s the power of diversification.
A diversified portfolio mitigates the damage of bad investments
If you invest in individual stocks that is probably because you think you have an edge. Perhaps you have a relative valuation process or you believe in trading off of technical indicators on charts. Whatever your edge is, having a diversified portfolio will allow you to exploit that edge to the same degree with less risk than if you had a concentrated portfolio. If your edge results in more money making decisions than money losing decisions, a diversified portfolio will benefit you over time as your good trades/investments outweigh your bad ones on a daily basis. If instead you decide to concentrate your trades due to “high conviction”, you will experience much larger swings in your portfolio even if you are using stop losses.
In this case multiple mistakes in a row can devastate your portfolio, making it difficult to get back to even. Remember that even if you flip a coin ten times there is a very small chance it will come up heads all ten times. In a diversified portfolio, bad luck on a few stocks is typically accompanied by good luck on others, leaving your returns to be based on your strategy, not luck.
A diversified portfolio will protect you from overconfidence and arrogance
Whenever you want to take a large position in your portfolio, ask yourself if the knowledge/conviction you have will compensate you for the additional risk. To make a point, lets go back to the example of investing in just Darden. You invest all of your money in Darden alone because you “know” the stock is cheap and it will soon rise. Even if you know the value of Darden will increase, you probably don’t know how long it will take to increase or the price it will increase to. If it takes 10 years for Darden to increase 100% including dividends, you will have earned 7% per year on your investment. Chances are you will have had to sit through some large swings over that time period.
Further more, you probably could have earned that same return by simply investing in an S&P 500 index fund with much less fluctuation. The bottom line is that overconfidence may make you a lot of money on a concentrated positions in the short run, but your returns in the long run won’t compensate you for the extra risk you’re taking. Maintaining a diversified portfolio will keep overconfidence and arrogance at bay by protecting you from making bad calls that may cost you dearly.
The easiest way to ensure you have a diversified portfolio is to invest in index mutual funds or ETFs. If you want to exploit an edge you believe you have in stock picking, the rule of thumb number of stocks for having a diversified portfolio with very little idiosyncratic (company specific) risk is 50. Even with 20 equally weighted stocks in your portfolio you will have much less risk than if you had just 5 large positions. Having a diversified portfolio is the best way to reduce the risk of holding individual stocks while still reaping the rewards of your trading/investment strategy.