The Pros and Cons of Portfolio Diversification

By: Andrew McShane

Portfolio Diversification can be helpful during volatile times in the stock market. But is it best for your returns over the long run? The Pros and Cons of Diversification

You are about to learn...

  • What is Portfolio Diversification?
  • The Benefits of Diversifying Your Portfolio
  • The Drawbacks to Portfolio Diversification

If there is a hot take in this article, it is that there is a downside to diversifying your portfolio. This isn’t a popular opinion, but if you are an investor who is seeking significant returns, you should take a close look at how diversified you are. You may be leaving some of those returns on the table. If this sounds controversial, then let’s examine the pros and cons of portfolio diversification.

Why is Portfolio Diversification Important? (The Pros)

Believe it or not, the primary purpose of portfolio diversification is not to increase the performance or returns of your portfolio, but rather help protect you against the downside when a market turns volatile or bearish.

If your portfolio is comprised completely of stocks and the stock market enters a correction into a bear market, more likely than not, you are going to suffer serious losses. However, if your portfolio is well diversified and you have a good mix of stocks, bonds, cash, or others, your losses will not nearly be as catastrophic. Essentially, you want to make sure that even if one part of your portfolio goes down, the others are stable or even increase.

Diversification goes beyond investment classes and applies to within the classes themselves. For example, to diversify your stocks, you may want to have a mix of small, mid, or large cap. Or perhaps, you want to diversify at a sector level and have a mix of tech, financials, energy, etc. There are a number of ways to diversify your portfolio and the strategy truly depends on your risk level and your financial goals.

Portfolio Diversification has proved its importance during times of great market upheaval. Take the dot-com bubble of 1999. Everyone and their grandmother were chasing the latest tech stock and in a little over 2 years, we watched the tech-heavy NASDAQ go from 1160 to 4336 to 1074.

Importance of portfolio diversification

A ton of people suffered tremendous losses during this time, especially new investors who caught the wave of dot-com and bought in at the top, only to see their investments almost immediately come crashing down. Savvy investors, who knew the importance of diversification, especially during a time that felt like a bubble, were able to mitigate their losses and recover quicker.

If you are a risk adverse investor, proper diversification is important, especially if you are planning on being invested for the long-term in the stock market. Huge crashes like dot-com and the 2008 financial crisis are rare but they do happen, so if you consider portfolio diversification a key component of your investing strategy, you will more than likely avoid catastrophes continue to realize solid returns.

The Case Against Diversifying Your Portfolio

Those who are against portfolio diversification will tell you “Diversifying your portfolio is purely psychological and not logical.” There is Nobel Prized research that tells us, “The intensity of a loss is twice as much as that of a gain.” This is particularly true in the stock market. Think back to the most recent correction. How many times did you check the news and your portfolio during that time? Now, how many times did you check your performance during the days of consistent gains?

Diversification allows us to feel safe during times of volatility and downturns. There is something inherently reassuring when the stock market turns, and you remember that you have 40% of your allocation in different assets besides stocks.

However, is this approach truly what is going to give us the best returns over the long run? Perhaps not.

Imagine that this was August of 1999. You were new to investing and there was a new wave. Everyone is getting in on this new technology fad, so you invested $10,000 into a brand-new tech ETF: XLK, the SPDR Select ETF for Technology.

You bought 278 shares at $36. In just over a year, you made $6,402 in capital appreciation at the top of the bubble when the stock price went up to $59. You were feeling pretty good. Suddenly, the floor drops out and you watch your entire portfolio crash down to $3,000 in September of 2002.

It was devastating for you, but you weren’t about to make that mistake again, so you diversified what was left of your portfolio and put 40% into a Vanguard Bond Market Index Fund (VBMFX) buying in at $10.38.

Now, let’s revisit the Nasdaq chart.

As you can see, over the next 20 years, the NASDAQ hit just continued to climb and hit a new high (checks watch) a few minutes ago.

So, what happened to your portfolio when you diversified into bonds? Well, you definitely avoided some heart palpitations during the 2008 correction but, as it was with the dot-com bubble, the market recovered and went on tremendous run.

If you had just left that $10,000 investment alone, your portfolio would be worth $36,418 today. However, because you diversified 40% or $1,200 into the bond fund, your bond investments would be worth $1,286 and your XLK shares would be worth $22,603. You would have left nearly $14,000 in returns on the table due to your diversification.

This is obviously a hypothetical situation but despite periodic corrections and down-turns, the stock market has consistently recovered, grown, and return large amounts of capital appreciation over the past century.

In summary:

This is not an article against diversification. Hedging against risk is never a bad thing. Especially since, after all, we are only human and sometimes our emotions get the best of us. Understanding your risk profile and mapping out your financial goals is the best way to ensure your investments are suited to your style.

However, sometimes just letting your stocks hold is the best way to realize returns if you are invested for the long-run in the stock market.

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