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The best way to manage risk

Diversification is a word you’ll hear advisors preach like there’s no tomorrow. They do it because it’s a responsible action for them to take to protect their clients’ wealth (and their own). In this Fool’s opinion, it can be harmful to your returns.

Diversification for the sake of diversification is more risky than not diversifying at all because it detracts away from our number 1 purpose as successful investors – to buy great companies at cheap prices.

If you invest for yourself, think what you’d prefer an investment advisor to offer: A mixture of 10 stocks, which contain a handful of great companies as well as some decent ones OR two to four of his/her favourite stocks that have been personally picked to grow your profits in the long term.

I know what I’d choose.

Advisors are taught to respond to an investors’ tolerance for risk and make investment decisions accordingly. What if, instead of risk, we spoke in terms of growth? So, for example, we’d say “what’s the best way to maximise your wealth in the long term?” instead of “what risk are you willing to accept to make a return?”

Generally, in a balanced portfolio we’d see a group of core stocks such as a big bank, a miner and a retailer, but in my opinion none of them are a standout ‘buy’ at current prices. Sure, during a financial crisis you’d come out better than someone who bought ‘riskier’ stocks… right?

RIO, CBA, WES, GOOG during GFC
Source: Google Finance

Wrong.

From the above graph, we can see that during the GFC even some of the biggest companies in world — including Google (Nasdaq: GOOG), Commonwealth Bank of Australia (ASX: CBA) and Rio Tinto (ASX: RIO) — lost 50% of their value. Diversifying into these companies would not have helped you avoid the risks of investing. However focusing on the growth opportunities that each company presented would have rewarded you well if you held them until today.

Foolish takeaway

Google, Commonwealth and Rio are undoubtedly great companies that will still be around in years to come, but buying a stock for the sake of diversifying is risky and at current prices the latter two are not cheap – which exposes you to even bigger risks.

It is important to diversify your portfolio to avoid as much risk as possible, but it’s inevitable that it will have some downside. It takes time to build up a diversified portfolio; in the meantime you should focus on buying great companies, whether they are all small caps, mid-caps or blue chips.

At The Motley Fool Australia we buy stocks which we believe are only the best and nothing else. After all, what better way is there to protect your portfolio than to buy great stocks at cheap prices?

If your struggling to find that perfect investment idea, we’ve got one you can have for free! Simply click here for your FREE copy of “The Motley Fool’s Top Dividend Stock for 2013-2014.”

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Motley Fool contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies.

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