Diversification: Is It The Key To Portfolio Management?
Although diversification has value as a prudent investment strategy, it also has limitations. Actually, it has only a few useful functions and it doesn't even begin to offer the amount of protection that many people think it does.
Simple logic tells us that the odds of acquiring a winning stock are better when more than one company is selected. It also suggests that safety is improved when investing in more than one company because the individual problems of one company probably won't affect the others in the portfolio.
Thus portfolio diversification can be properly defined as the placing of financial assets into significantly different investments, for the purposes of increasing the chances for larger profits, protecting against losses, and simplifying the analysis and selection process.
A practical diversification strategy that will protect all of the original capital is to buy U.S. Treasury bonds, and then use the interest from them for investing in the stock market. If the bonds are held to maturity, the principal is never at risk. Instead, it is returned as the bonds reach maturity.
Diversification is important as an investment strategy. However, while it can be used to lower the overall risk and increase the chances for better profits, it is also important to remember that risk is not eliminated with any form of diversification.
One should also pay close attention to the comments of Warren Buffett concerning diversification. According to Buffett: "Diversification is only useful to persons who really don't know what they are doing." And then Buffett also tells us: "Do put all of your eggs into only one basket, but then watch that basket very carefully!"
And finally, I would point out the three major flaws to diversification as explained by studying the Zurich Axioms:
1. Diversification forces you to violate the precept that you should always play for meaningful stakes.
2. By diversifying, you create a situation in which gains and losses are likely to cancel each other out, leaving you exactly where you began - at Point Zero.
3. By diversifying, you become (in effect) a juggler trying to keep too many balls in the air at the same time.
When you think about these three major flaws of diversification and weigh them against its single advantage - safety - it begins not to look so good!
And as for an answer to the question that started off this topic, I will leave it to the readers to furnish that for themselves.
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Simple logic tells us that the odds of acquiring a winning stock are better when more than one company is selected. It also suggests that safety is improved when investing in more than one company because the individual problems of one company probably won't affect the others in the portfolio.
Thus portfolio diversification can be properly defined as the placing of financial assets into significantly different investments, for the purposes of increasing the chances for larger profits, protecting against losses, and simplifying the analysis and selection process.
A practical diversification strategy that will protect all of the original capital is to buy U.S. Treasury bonds, and then use the interest from them for investing in the stock market. If the bonds are held to maturity, the principal is never at risk. Instead, it is returned as the bonds reach maturity.
Diversification is important as an investment strategy. However, while it can be used to lower the overall risk and increase the chances for better profits, it is also important to remember that risk is not eliminated with any form of diversification.
One should also pay close attention to the comments of Warren Buffett concerning diversification. According to Buffett: "Diversification is only useful to persons who really don't know what they are doing." And then Buffett also tells us: "Do put all of your eggs into only one basket, but then watch that basket very carefully!"
And finally, I would point out the three major flaws to diversification as explained by studying the Zurich Axioms:
1. Diversification forces you to violate the precept that you should always play for meaningful stakes.
2. By diversifying, you create a situation in which gains and losses are likely to cancel each other out, leaving you exactly where you began - at Point Zero.
3. By diversifying, you become (in effect) a juggler trying to keep too many balls in the air at the same time.
When you think about these three major flaws of diversification and weigh them against its single advantage - safety - it begins not to look so good!
And as for an answer to the question that started off this topic, I will leave it to the readers to furnish that for themselves.
* * * * *
posted by Bob Moser at
4:50 PM
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