Diversification… although we investors perhaps hear this word more than most, it is still a misunderstood concept and one that can be detrimental to your returns. Any financial planner or advisor would tell a client that a ‘diversified’ investment portfolio is the key to building wealth and that efficient market theory tells us that a diversified portfolio is the ‘only free lunch’ in investing – lower risk and higher returns. But before you diversify your life away, it’s not all that simple.
To be or not to be… diversified?
The greatest investor of all time – Warren Buffett – once stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” Mr Buffett has a point – most of the wealthiest investors are the furthest thing from diversified. How many public stocks do you think Elon Musk owns? Or Mark Zuckerberg? Or Jeff Bezos? Or Buffett? It’s definitely nowhere near a ‘diversified portfolio’.
In my view, the best path for the average investor lies in between two extremes. I don’t think it’s a good idea for anyone to put all eggs in one, two or three baskets (unless you’re running a multi-billion dollar company). But I think diversification has limits too. Some advisors will tell you that you have to ‘be diversified’ across stocks, cash, bonds, property and gold. After that, you can ‘be property diversified’ across residential, commercial and industrial property. Or ‘be stocks diversified’ across developed markets, emerging markets, ASX markets or maybe US markets. Or dividend stocks and value stocks and growth stocks… you get the point.
There is a point (in my view) where a diversification strategy can be deleterious to successful long-term wealth building – you can’t buy everything, after all.
A better path than blind ‘diversification’ (in my opinion anyway) is learning how to find good investments. It’s simple. Pick your battles in the areas most likely to succeed and diversify across them. If you have one good quality investment property, find a couple of stellar growth stocks like Afterpay Touch Group Ltd (ASX: APT) and a couple of top-notch dividend payers like Ramsay Health Care Limited (ASX: RHC), then you’ll have yourself a high-quality investment portfolio that (in my view) is more than adequately diversified.
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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Sebastian Bowen owns shares of Facebook and Tesla. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Facebook and Tesla. The Motley Fool Australia owns shares of AFTERPAY T FPO. The Motley Fool Australia has recommended Facebook and Ramsay Health Care Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.