Portfolio Construction : To Diversify or Not to Diversify ?

As investors, when we think about Risk-Reward analysis, the first thing pops up in our mind automatically will be the word “ diversification”.  

This is what been mentioned in Investopedia about the importance of Diversification :

"Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.”

There are also different types of diversification e.g  Asset class Allocation, Diversification by Geographical and Sectors etc.

You may find out the 6 types of diversification from Investopedia :

6 Types of Diversification for Your Portfolio (Click Here )

We knew the importance of diversification but also quite often we hear the other side of the story that diversification may have some drawback eg, overly diversifying an investment portfolio tends to reduce potential gains and produce only, at best, average results.

Also, during recent GFC ( Global Financial Crisis), we have seen that regardless of an asset class, most of the asset (equity, bond, commodity, real estate ) being affected and suffered from the tumbling in stock price which makes most of us question the effectiveness of diversification.

To Diversify or Not to Diversify?

So what should novice investors do? Diversify or not diversify? Well, one has to trade off the loss of the upside with the protection on the downside. You need to ask yourself which is more important to you. 

For most people, the pain from losing money is felt more deeply than the joy in gaining the same amount on the upside, commonly called "loss aversion." 

If you are like that, then protecting your investment from the downside risk is a more urgent issue. The more loss-averse you are, the more you need to build a safety margin for your portfolio. And diversification is a powerful tool to build that safety margin.

More about “loss aversion “ from Wikipedia ( here ) :

“In economics and decision theory, loss aversion refers to people's tendency to prefer avoiding losses to acquiring equivalent gains: it's better to not lose $5 than to find $5. Some studies have suggested that losses are twice as powerful, psychologically, as gains. Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman.

This leads to risk aversion when people evaluate an outcome comprising similar gains and losses; since people prefer avoiding losses to making gains.”…….

Other than “Risk tolerance “, the diversification strategies will also be determined by your stage of investment cycles, eg, in the early stage of wealth accumulation, one may have a more concentrated portfolio but towards retirement age, a more diversify portfolio may have peace of mind although with less potential of growth or capital appreciation.

No doubt that diversification is a good thing but building a diversified portfolio has never been easier for individual investors.

How about your story of portfolio diversification?

Cheers!

Quote Of The Day :

"Every once in a while, the market does something so stupid it takes your breath away." - Jim Cramer

My way of diversification:  A “Kiasu “ Equity Portfolio :

You may notice that I have a diversified portfolio ( latest update here ) with 48 stocks in total, although not in sectors wise where I try to reduce my exposure in REITs and Business Trust in the last two years, where I have blogged about it – here (part 1)  and here (part 2) .

As I mentioned before, a few multi-bagger stocks in my portfolio may not change the overall return much since I am allocating less than 10% of my capital in each counters.

Similarly, my top 5 worst performance in my portfolio ( with negative return ranging from -7% to -17% ) only constitute about 8.7% of my total portfolio. If any of these company goes “kaput “, it will not have a severe impact on my overall portfolio value, hence allow me to sleep well.

Detail of my “Kiasu “ Portfolio as below :