A Diversified Portfolio is Risky – Here’s Why

Currently the market is disturbingly turbulent. During times like these, some investors think that a diversified portfolio is their key to investment security.  I agree that it might help in certain circumstances.But in other cases diversification can be a very risky approach. That’s right. Often a diversified portfolio will expose you to much more risk than a narrowly focused portfolio would. Before we discuss this, let’s agree on our terms.

What is a diversified portfolio?

Some define a diversified portfolio of growth stocks as one that holds many different stocks in many different industries. A diversified portfolio of  funds would hold a variety of funds invested in small cap, large cap, growth, value and international sectors as well.

Others take the term diversification to mean something else entirely. They require you to have equities, bonds, commodities and real estate in your portfolio in order to consider it diversified.

So before we can agree that diversification increases or decreases risk, we need to agree what diversification is and the investment community hasn’t done that yet.  Lets keep going anyway.

Would you like some help with managing your portfolio?  If so, let me know.  I’d be delighted to answer your questions.

Why do investors like to diversify?

Regardless of how you define it, the idea behind a diversified portfolio is that you should have a wide variety of different investments. That way, if one or two position do poorly, the other holdings might do well and make up for it. It’s the old adage of not having all your eggs in one basket. To the extent that each holding differs from the others your risk decreases according to the proponents.

Of course these arguments are valid – but they don’t tell the entire story. Even though diversification has its benefits, it has its drawbacks too (some of which are very serious and are often overlooked).

1. Watered-Down Returns.

It might be hard to think about making gains right now, but have perspective. Over a long investing career, there are both good and bad years.  By having your money in many different asset classes, your returns are diluted in good years and they tend to outnumber the bad ones.

You could have a handful of big winners but it won’t make that much of a difference if your portfolio is widely diversified. In order to do well you will need many positions with great returns. Here’s a real-world example of a diversified portfolio and the corresponding returns:

Now, here’s an example of a more focused portfolio:

Admittedly, the past is no guarantee of future results and the time periods are different.  But you can see that a more focused portfolio has the potential for greater returns – as well as greater losses in any one year.

2. No Safe Harbor

If 2008 taught us anything it’s that all ships rise and fall with the tide.  (We’re also getting a taste of this right now.) In other words, there are times when most stocks rise in price and there are other times when all stocks most get clobbered. In such circumstances, diversification won’t do many investors any good. Even people who bought real estate and/or commodities got soaked in 2008. And everybody is going through it right now.

Why?  Because asset classes move more and more together in lock-step because of technology and globalization. Consider the Russell 1000 Growth Index and the Russell Value Index 1000. According to Investment News Magazine these indexes use to respond to the market very differently. In fact, between 1990 and 2000 they only moved together 57% of the time. But since 2000 these two indexes now move together 92% of the time. So much for safety in diversification.

And when it comes to international investing, the correlation much better. Emerging markets used to have almost no correlation what-so-ever with the Russell Growth Index. Now these two indexes move and up and down in a similar fashion 89% of the time.

3. False Sense of Security

This is a huge problem especially right now.  Even if you have a diversified portfolio you might be taking some pretty painful hits right now.  Just like people who bought target date or lifecyle funds and incorrectly thought they had a safety net, investors who rely on a diversification strategy for protection ignore the realities of the market. More and more world markets are intertwined with each other as I said above. Having a diversified portfolio in a declining market is like rearranging the deck chairs on the Titanic. No matter what you do, you’re going to get wet.

Rather than rely on diversification to provide safety you must understand two things:

1. If you invest using diversification as your primary means of reducing investment losses, there will be times when this will not work and you will suffer great losses.
2. If reducing investment losses is a primary concern should consider alternative investment tactics.

I’ve written about market timing in the past because that is one such alternative. And when I refer to this I am not suggesting that you sit behind a computer terminal and trade stocks all day long. I am not talking about day trading and I am not suggesting you use your gut feeling to guide your investment decisions.

I am talking about using a strategy that measures risk and moves out of the market at one time or another based on a well thought-out strategy. Some market timers move out of the market several times a week. Others move their money in or out of the market a few times a year or once every several years. This depends on the systems they use. Each system has its pros and cons and there is no one market timing strategy that is perfect. Indeed, just because you use market timing, you have no guarantee that you’ll do any better than those investors who employ a diversified portfolio at any given time. Sometimes you’ll do much better. Other times you’ll do much worse.

What this boils down to is that in order to be a successful investor you should really understand what your strategy is engineered to do. There are plenty of benefits to using a diversified approach to investing. But maximizing gains and protection against catastrophic loss are not always guaranteed using this (or any approach). Unfortunately many investors think that diversification does deliver that safety when it doesn’t.

Do you have a diversified portfolio?  Why or why not?  What have your results been recently?