The Pitfalls of Diversification

“Diversify, diversify, diversify” – how many times have you heard that phrase? It is such a common phrase to the extent that nowadays, it is used out of context. Diversification can be a blessing or a curse depending on how it is implemented. Most people think by diversifying they automatically have eliminated risk in their portfolios. This can be false because diversifying into over-valued securities at the wrong time is a sure path to future losses. The key to diversification is buying under-valued companies with the right timing. Timing here does not have to be extremely precise i.e. you do not have to time it to the right day. Timing here could be the right quarter of the year. Below I will discuss some of the pitfalls to diversification and what is required to avoid such pitfalls.
Diversification without a sufficient amount of research
Putting your eggs in many baskets philosophically sounds good but putting your eggs in the wrong baskets is obviously the wrong thing to do. Most folks get obsessed with diversifying that they forget to perform due diligence on the stocks they select. When selecting a company to invest in, you have to ask yourself a few questions. Does the company have good growth potential that would lead to a higher market value in the future? Is the company currently in a good financial position after studying its balance sheet, income statement, and cash flow statement? Is the company under-valued and maybe trading below their book value or trading below their discounted future cash flows? What will be the future of the industry the company is in and how will political mandates and fiscal policies affect the business? If a company checks all the boxes then it is a viable candidate to put in the basket for diversification. It is important that the basket be filled with stocks encompassing different industries as that would minimize the risk towards one particular sector although I would say it is okay to have the overall weighting slightly weighted towards industries with better future growth prospects.
Diversification without continuous re-balancing 
This is where the classic “buy low, sell high” comes into play. It is great having a properly diversified portfolio to start off with but it is more important to continuously re-balance as the portfolio generates dividends to take advantage of under-performing stocks within the portfolio granted that all the stocks in the portfolio are quality companies. You can think of it this way, the dividends from company A (which is currently out-performing from a stock performance stand-point) can be put towards company B (which is currently under-performing due to some known reason such as a short-term quarterly miss or a recent sell-off due to a minor reason the street is concerned about in the short term. It might be a cumbersome task trying to move the dividends around in a portfolio account which is why investment platforms such as M1 Finance do that for you for free. I have thoroughly reviewed the investment platform. The truly FREE investment platform offers automatic re-balancing, investing the dividends or new money in the underweight stocks thereby leading to better future returns when those stocks bounce back to expectations.
Not keeping track of investments and stretching yourself too thin 
Now having too many stocks within a portfolio can slowly lead to situations where you cannot keep track of the daily performance of all of them. There will be situations where an announcement stating the acquisition of the company could be made at a higher multiple. It is important to be aware of such happenings as that could provide an exit point that could boost returns. I have personally had acquisition announcement situations like this and I was able to find out quickly and place a trade to take advantage of the gains. Those trades are free using M1 Finance and I could re-direct the gains towards another under-valued company I was researching. A FREE money management platform called Personal Capital is such an invaluable tool as it keeps track of every single stock within your portfolio and provides a comprehensive look at the daily performance of each of them relative to the general S&P 500 or Dow Jones indices.
Diversifying into investment vehicles that don’t keep up with inflation
The worst form of diversification is placing them in a portfolio that does not keep up with inflation. Since we know inflation leads to a decrease in the value of the US Dollar over time, it is important to be able to at least match it to keep the same financial value. Only purchasing low yield treasury bonds and companies with an consistently low year-over-year performance with zero dividends paid will have a hard time keeping up with inflation. The inflation rate over the past three years has hovered around 2% as shown below. It is important to keep track of the performance of your investments on a year-over-year (YOY) basis to make sure that diversification is not actually hurting you by allocating too much into low yield investment vehicles. Again free tools such as Personal Capital helps keep track of your portfolio performance very easily.


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