To diversify, or not to diversify: that is the question

When it comes to investing money, there is an inherent conflict or tension about how to do it.

By AARON KATSMAN
February 11, 2010 06:27
2 minute read.
To diversify, or not to diversify: that is the question

money 88. (photo credit: Courtesy)

 
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When it comes to investing money, there is an inherent conflict or tension about how to do it. While some people believe in diversifying their investments, there are those who do just the opposite – they invest large amounts of money in a few, concentrated investments. The question is: Which is the better approach?

Diversification

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Diversification is an investment technique that uses many varied investments within one portfolio. According to modern portfolio theory, different kinds of investments will, on average, yield higher returns and pose a lower risk than any single individual investment.

Diversification tries to smooth out volatility in a portfolio caused by market, interest-rate, currency and geopolitical risks. In layman’s terms: Don’t put all your eggs in one basket. Although you may not get rich quickly with a diversified portfolio, over the long term you may continue to build up the value of your assets.

Putting all your eggs in one basket

If Bill Gates had diversified, he would not be where he is today. If Gates had sold off his Microsoft stock 20 years ago and created a diversified portfolio, he may still have been well-off, but he wouldn’t be one of the richest men in the world. This is the theory used by those investors who buy only a few different assets but put a large percentage of their wealth in them.

In a recent interview, master investor Warren Buffett said when he started out 50 years ago, he thought he was going to be “doomed to a life of asset allocation” – meaning that he thought all he would do is create well-diversified portfolios for his clients.

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When it comes to diversification, many people ask why they should invest in something they either don’t like or don’t think will appreciate in value. If an investor doesn’t think the investment will go up, what’s the point of owning it? The implication of the question is that they should only invest in something they think will make money now.

What’s the answer?

There is no definitive answer to this fundamental question. What works for some investors doesn’t necessarily work for others. There is certainly logic in investing in something you believe will increase in value. But the reason people such as Gates and Buffett are famous is because they were so successful with their concentrated investing style; we don’t usually hear the stories of those who lost it all by this style of investing. For most people, the responsible way to grow assets over the long run is to continue to save and to diversify.

But there is no clear answer for why you should invest in something you don’t think will go up or you don’t believe in. Just because a person doesn’t like something or doesn’t think an investment will appreciate, doesn’t necessarily mean that’s what will happen. Diversification is about lowering risk and trying to not just preserve principal but to grow it as well.

Ultimately, both approaches have the same goal of significantly growing your principal over the long term. The advantage of diversification is that even if you don’t become rich, you won’t end up in the poorhouse with nothing to show for years of hard work and saving.

aaron@lighthousecapital.co.il

Aaron Katsman, a licensed financial adviser in the United States and Israel, helps people who open investment accounts in the US.

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