Diversification is a must for all kinds of investors. In fact, if you are a newcomer in the world of investing and seek financial guidance, any advisor will recommend you to start shaping a diversified portfolio.
The goal is clear, the more diversified your portfolio is, the fewer risks you have. However, it’s important not to overdo it. If you were excessively diligent in asset allocation, then brace yourself for a possible failure. There is a special term ‘diworsification’ coined by financial analysts. The word is used to describe a situation, when diversification has a negative outcome and decreases risks below average.
The earlier you realise your portfolio is diworsified, the easier it will be to fix it. Here are top four signs that say you should re-build your investment strategy.
You’ve Invested in Non-Traded Assets
Non-publicly traded assets are assets with a stable income. This grouping includes real estate, hedge funds, private equities, etc. These securities are often overestimated, and the risk they pose is overlooked due to the mistake in volatility calculations.
The thing is, the value of ‘alternative investments’ is determined based on estimates, while daily market data is not considered. Consequently, you are not able to understand their actual performance and the risk/reward ratio.
Don’t judge based on stable income. Non-publicly traded assets are not necessarily a safe heaven. Be careful while buying into them. Otherwise, it can lead to over-diversification.
You Put Down Money to Similar Mutual Funds
Investment choices abound. There are so many of them that it can confuse you. Each mutual fund assures you it is unique. The diversification theory cries out “Diversify!” So, what move will be smart?
While it may be difficult to pick up the right option, make sure you don't chase after all the opportunities you see. Think carefully. Two absolutely different mutual funds may have an identical strategy and one type of investment. Holding the same assets is costly and inefficient.
To look through the mutual funds’ characteristics, refer to Morningstar’s ratings. The agency specialises in investment research, it provides information and data on almost all kinds of investments (mutual funds, shares, indices, etc.). Also, the firm offers financial advice services. Thus, sorting out the good and the bad, you will be able to really diversify, not diworcify, your portfolio.
You Rely on Multi-Manager Investments
If you want your portfolio to be controlled by a few fund managers, then be ready that each of these managers may turn out to be a poor team player. It implies that his decisions can go against your strategy and the overall outcome will be affected. In addition, you’ll have to pay greater fees in comparison to a single-managed portfolio.
It is much easier to monitor one manager, than to keep an eye on a number of them.
You Hold Many Individual Shares That Are Mostly Similar
There is a popular assumption that a well-diversified portfolio should include 30 individual stocks tops. But that’s a controversial matter. Another theory contends that you can invest in 300 various stocks and that will still be a good diversification.
Edwin J. Elton and Martin J. Gruber, in their book ‘Modern Portfolio Theory and Investment Analysis’, carry out a study to determine the optimal number of stocks in a portfolio. There isn’t a fixed and adjusted amount. The rule of thumb is to invest in various industries and not to focus on one sector. For example, to concentrate entirely on medical companies and ignoring other industries, that may be booming in a few years, isn’t a smart move.
Putting down money in uncorrelated securities has many benefits. And ‘the right’ diversification is just one of them.
What’s It All About
Diversification doesn’t always protect you from risks. The key to success is to do it smart. If you want to spread risks, don’t do it recklessly and try to avoid an ‘include everything’ rule. Think carefully, consult a financial advisor, track the performance of every asset in your portfolio. And ensure diworsification won’t happen.