why is diversification important in investing

Smart Diversification Vs. Dumb Diversification

Most investors understand the logic behind diversification. But not all forms of diversification are created equal. Imagine you’re back in elementary school, you’re in gym class, and you’ve been nominated the captain of your dodge ball team. Which kids do you think you would pick to be on your team? Would you just pick people at random? Or would you only pick the strongest, fastest, and most talented players to be on your team?why is diversification important in investingDiversification is the idea that it’s really hard to pick a winner with absolute certainty. So it makes sense to spread your investment allocations out over multiple assets. That way if some do poorly, they can be potentially balanced out by those who do excellent.

But for some reason, the financial industry has taken the idea to spreading your bets out to the extreme. Rather than picking 10 or 20 financially promising assets to invest in,  mutual funds that spread out over so many different stocks and bonds that you are locked into the mediocre market performance.

Why Traditional Diversification is Dumb…..

Warren Buffet is known for his ability to value stocks, and pick winning investments that outperform over the long haul. He’s able to do this because he only puts the best players on his team. Every business he picks has to have strong financials, a durable competitive advantage, and modest debt. That’s why his average rate of performance is over 20% annual.

But traditional Wall Street Diversification truly is picking companies at random. They have to pick stocks at random simply because they are buying so many different stocks. Mutual Funds can have hundreds or even thousands of stocks. There just aren’t that many wonderful companies that you could invest in. If they bothered to take a closer look, they would see that many of those stocks just don’t make any sense from a business perspective.

True Diversification……

Instead of spreading your bets so thin that you barely break even, why not only put all-stars on your team? True diversification means that you are spreading out to many different assets besides paper securities, and you’re doing it with some level of business sense. While an amateur investor might think they’re well diversified between stocks, bonds, and CDs, they fail to realize that these are all paper assets that can fluctuate based on economic events. During the last crash back in 2008, not only were stocks down, but so were bonds. Diversification didn’t do a great job when the economy started to tank.

But somebody who truly diversifies can actually make a ton of money when the economy starts to decline. A true diversifier will stock pile many different assets including stocks, real estate, gold, private business, mortgage notes, etc. Smart diversification means focusing on the best deals at all times.  If stocks are expensive, but real estate is cheap, buy real estate.  If oil is statistically overbought, and gold is statistically oversold, buy gold.  It’s about buying into weakness such that all of your acquisitions have a superior margin of safety, and a higher probability of recovery.

So if you want to create true stability, and also potentially increase your overall performance, stop picking players at random. Build an all-star team of field tested players likely to outperform.

 

About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

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