Seven occasions when you should avoid diversification
Conventional wisdom dictates that investment diversification is essential to long-term success.
What is diversification?
When we talk about diversification in an investment portfolio, which might include a KiwiSaver Scheme investment, we're referring to the investor attempting to reduce exposure to risk by investing in various companies (shares) across different sectors, industries, and countries. To keep the explanation going, with an investment like KiwiSaver, most schemes have well-diversified funds which also spread investments into other assets classes (aside from just shares) such as listed property, infrastructure, and bonds.
Most investment professionals agree that although diversification is not a 100 percent guarantee against loss, it is a clever strategy to work towards long-term financial objectives. Countless studies support that diversification works.
However, there are more than a few situations in which diversification might not make sense. Here are seven examples.
1. You accept the increased risk and want increased returns
Holding a concentrated portfolio of just a few shares – perhaps focused on small and emerging technology or healthcare companies – might yield a spectacular result. This will be in the form of increased return when compared to the rest of the investment market. But that potential return comes at a price: you’ll surely have to accept drawbacks such as increased volatility (prices fluctuating up and down), and instead of a spectacular return you also run the risk of severe losses.
2. You’ve got nothing to lose
The typical NZ investor using online share platforms probably fits into this category. The average investment size on these platforms is tiny, and in this case any losses won’t impact on your ability to retire, buy a house, or achieve some other major goal.
The opposite to this is someone investing their life savings after a few decades of work, perhaps for the purposes of building up a retirement nest egg. In this case, diversification is a no-brainer!
3. You don’t care, it’s flutter money
Following-on from point #2, lockdowns have kept many of us at home and cancelled more than a few sporting events. It seems many people have turned to online share trading platforms instead of placing sports bets.
In this case, the funds invested are more like spending money than for any other purpose, so potential losses may not trouble the investor at all – for example, investing heavily into an unprofitable company that’s invented something which may succeed spectacularly, or which may fail and lead to the company soon going bust.
This approach could also apply for people who are just starting out with tiny sums.
Unlike sports betting, this sort of approach may lead the ‘investor’ to learn a few things along the way.
4. You’re a small business owner
Many small business owners, especially those who are a long way from wanting to retire, might do best by reinvesting any profits into their business. This could be in any number of areas, including to: fund acquisitions of other companies, more equipment or stock, bring on more staff to grow, invest in research and development, marketing to obtain more customers, or in some other way.
5. You know exactly what you’re doing
In the simplest possible way:
Diversification means you need to get it right slightly more than 50 percent of the time, but
If you don’t diversify, you must get it right nearly 100 percent of the time!
Investment professionals, or those with extensive knowledge in one area of an investment market, can have a lot more information at their fingertips than enthusiastic part-timers. This can develop more confidence and conviction in certain investments and might lead these people to be more concentrated in their investment approach than others – there’s a better chance they’ll be nearer the 100 percent win rate required.
These people typically can bring to bear the effort, intensity, and time needed to successfully concentrate an investment portfolio. Even so, this sort of approach still isn’t for the faint hearted! The most informed can still get in wrong as was demonstrated with one institutional investor who lost 20 billion!
6. You’re saving for something specific
Planning on buying a home within the next year or two? In this case, it’s probably best to just hold your savings as cash. Cash, including term deposits and money in savings accounts, isn’t diversified and is vulnerable to inflation, but it’s about as safe as you can get for periods of less than a couple of years. You’ll have peace of mind knowing that you’re very unlikely to lose your deposit.
7. To avoid high costs
The easiest way to diversify is usually with managed funds, which can include KiwiSaver Schemes, but also includes ‘unlocked’ investments that can be accessed at any time.
Unfortunately, diversification is commonly used as a sales pitch for funds or other investment products that can resemble syndicated real estate products, unneeded life insurance, and other high fee offerings. A common message to investors is instead of diversifying from traditional shares & bonds, diversify into other higher-cost solutions focused on other specific sectors or strategies. The high fees and risks are usually not understood by most investors.
Investors will always pay fees, even a small-time share investor will still have brokerage to pay for buying and selling shares and other investments. The key is to ensure those charges are reasonable and represent good value.
The bottom line – when and why you should not diversify
Diversification usually makes perfect sense, and as it’s so hard to argue with the common sense behind investment diversification, the list above could be considered controversial.
If you’re considering going against the crowd and ignoring diversification, not only will you need nerves of steel, but you’ll also need to watch your investments like a hawk and change your approach should the outlook for one or more of your small selection of investments change. Of course, you’ll also have to do a lot of research to ensure the small number of investments you hold have the best possible chance of success.
As always, what you do financially depends on your temperament, your current situation, desired future situation, and the risks you’re willing to take (or not take!) to get where you want to be.
If you'd like to discuss your investments and overall financial situation with a trained professional, then get in touch.
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