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What does diversification really mean?

Ramit Sethi

There are some things so entrenched in our culture that we never stop to think what they really mean. Let me direct you to one of the most striking examples in the last 10 years: The Backstreet Boys’ hit, I Want It That Way. This god damn song is so catchy that, while we were all singing along and bopping our heads, we never stopped to think about what the lyrics actually meant. Consider:

Tell me why
Ain’t nothin’ but a heartache
Tell me why
Ain’t nothin’ but a mistake
Tell me why
I never wanna hear you say
I want it that way

Now I am an educated man, but I can’t find any deep meaning in those (admittedly soulful) lyrics. To be honest, I don’t understand what the hell they mean. But I keep repeating the words because the beat is so good.

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A pretty similar thing has happened with the phrase “diversify your portfolio.” We all say it, but why is it really important? And how do you actually do it?

Why diversification is important
Diversification means not investing everything you have in one area. For example, if you put all your money in one stock, or all in technology stocks, or even all in real estate, you’re not diversified.

It’s important to be diversified because if that stock does down (let’s say down 20% or even bankrupt), all of your money could be wiped out. “But Ramit,” you might say, “that’s good advice, but I own stock in a big company. I doubt they’d go down 20% all of a sudden.”

I would respond to that in 2 ways: First, I would bet you a nice dinner that you were wrong. See, I like to make bets that I’m sure I’ll win. Second, I’d point out Ebay’s stock in January ’05. Ebay is a huge company with a ~ $47 billion market cap, but when it reported that it missed Wall Street expectations by a penny–that’s right, one penny–its stock dropped nearly 20% in one day.

ebay.gif
Source: http://finance.yahoo.com

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Diversification is also important because, with all due respect, you’re not that smart. Don’t worry, neither am I. Hell, nobody is. Why do you think so many people lost their money in the dot-com bust? I remember overhearing one elderly couple at the mall a few years ago; the husband was basically explaining that he was diversified because he’d invested in 5 different companies that were…wait for it…Cisco, Microsoft, Amazon, EBay, Symantec, and something else I don’t remember. Listen, you can invest in 200 stocks, but if they’re all in the same sector, you’re not truly diversified.

One final point: A lot of people think that, because they own a mutual fund, they’re automatically diversified. This is sort of true, but not really at all. Check it: There are tons of types of mutual funds including “sector funds,” which invest in certain sectors. If you want to own a bunch of biotech stocks, for example, you could buy a sector fund focusing on biotech. The implication is clear: If biotech does poorly as an entire sector–maybe the government levies regulatory pressure on development or scientists suffer one setback after another–investors may pull out and the entire sector will go down in value. As a result, so will your money. Just because you own a mutual fund, you’re not automatically diversified.

The second concern with mutual funds is that some people own more than one, and the stock holdings might be duplicated, leading to less diversification than you think. Let’s say you own a small-cap mutual fund, a technology fund, and a growth fund. Those three funds could all hold the same stock; if it performed poorly, it could have a disproportionately negative influence on your holdings.

The implications of diversification
True diversification protects you from loss because, even if one your investment holdings completely tanks, it won’t drag down the rest of your portfolio. But diversification also limits your potential upside: If one of your stocks jumps 500% (but it’s only 10% of your portfolio), it won’t take your portfolio up that much.

This is a tradeoff you’ll have to carefully consider. A couple of points might help: We are more motivated by loss avoidance than by potential gain. In other words, we’d rather not play a game in which we might lose 50% even if we had the potential to gain 200%. Also, even though it’s true that you limit your potential upside by diversifying, if you pick good investments and hold them for a long time, you can expect substantial returns.

How to diversify
A few months ago, I was talking about finance stuff with one of my friends who’s actually a pretty sophisticated investor. When I asked him how many stocks he owned, he told me that he held 20. I asked him 2 questions: “What the hell are you wearing?” Seriously, he had a ridiculous outfit on and I was embarrassed to be seen next to him. But then I asked him why he owned so many stocks.

“Diversification,” he told me. Now let’s keep it real. Owning 20 stocks is stupid and I told him so. You simply can’t focus on 20 investments (tracking, reading the prospectuses, comparing them to their peers, etc). Also, with 20 stocks, even if one stock goes up 10,000%, it’s such a negligible part of your portfolio that you’ll hardly realize any gain.

I recommended that he pick his best 5 stocks, sell the rest, and think carefully about where to put the money–either back into his select 5 stocks or an index fund (or both).

You can start diversifying by deciding which investments you’re going to make (see All About Stocks and Bonds and All About Mutual Funds to start off). Also note that there are other investments besides these two areas but stocks/funds are excellent starting points. Remember, you can diversify by sector (e.g., retail vs. technology), size (e.g., small-cap vs. large cap) strategy (e.g., growth vs. income).

If you already own mutual funds, you can use a mutual fund screener to make sure your funds don’t have too much overlap.

Then decide how much of your portfolio you want each investment to be–and rebalance at the end of every year (for example, if one stock jumps up 5,000%, it probably now holds a higher percentage of your portfolio and you may want to adjust accordingly). Finally, if you lost that bet with me at the beginning of this article, you can take me out to dinner. Mondays and Wednesdays are good for me.

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4 Comments

 
  1. The Dividend Guy

    Good artcile. So what percentage do you consider to be a good guideline amount for a particular holding – is it 5% max, 10% max, 2% max? I would like to hear your thoughts on this.

  2. pc

    Interesting article i suppose but would you be able to send me articles about diversification , financial analysis, and corporate finance.I like your jargon, just intriguing.

  3. Danielle

    In response to PC’s comment. One of the best resources I’ve found that breaks down financial terminology and has wonderful tutorials is Investopedia. (www.investopedia.com)

  4. kk

    lol