What you are about to read may enlighten you. Or, if you are a savvy investor, what follows may re-enforce what you already know. However, if you strongly believe that diversifying is a way to reduce risk and practice the often-repeated phrase, "don't put all your eggs into one basket", then - not to be rude but - you may not want to continue beyond this sentence.
Well, you are still here. That is good, especially if you are under the influence of the "diversify to reduce risk" way of thinking. It's sacrosanct to many in the investment industry and my statements below are iconoclastic. They go against the widely held belief that diversifying reduces risk and will, frankly, piss off many people.
However, knowing that you are continuing to read this shows that you want to discover a different perspective on diversification. It shows you care about your money, your future, and your loved ones' futures.
You will learn why many financial advisers choose diversification as their main investment strategy along with two very important reasons why diversifying can increase investment risk.
Learning why diversification is not the ideal risk reduction method may prevent you from having below average returns, or in some instances, it may even protect you from massive financial losses. And I don't want that to happen to you. So, please read on…
1. First Reason as to Why Diversification Can 'INCREASE' Investment Risk…
So, what is the first way that diversification can increase investment risk? In short the answer is: diversification is spreading money around with the hope that, in the end, money will be made. Diversification more than likely is due to a lack of knowledge and confidence in what to invest in properly. Without proper due diligence into what is bought in the diversification purchase and an awareness of impactful industry and economic developments, diversifying is the equivalent to throwing wild, unfocused and untimed punches in a fist-fight as opposed to covering up, bobbing, weaving, and feinting to test your opponent's skills and wait for an opening where you will then direct a 100% calculated strike at the jaw line, scoring a knock-out. The former will drain your energy (and if you're in poor shape, bankrupt it), and open you up to being hit or outright pummeled. Conversely, the latter puts you in a position to see an opportunity after closely observing your adversary. By studying what you're going up against mindfully, you gain an understanding of how your opponent operates and can capitalize on weaknesses and gaps, such as does the antagonist lower the arm after throwing a jab or keep the jaw unclenched.
Leaving this metaphor and jumping into the investment arena, analyzing investment choices closely, understanding how they move, and knowing what the influential factors are before investing in them gives you a much better chance of either avoiding a financial loss or scoring a massive gain, (i.e. a knockout, with just one investment.)
Diversifying without a lot of attention to influential details is a dangerous way to use investment money. You cannot diversify away risk because risk can't be eliminated. Risk can only be exchanged, transferred or hedged.
Unfortunately, you may not have the time to devote to not only researching investment opportunities but also developing the analytical and business knowledge necessary to make prudent investment choices. If this is you, don't feel bad. Surprisingly, many financial advisers (FAs) suffer from lack of time as well.
Many FAs are charged with bringing in new clients to help their investment firm gain wallet share. This is their main responsibility rather than making certain the money under their watch is in the most secure and best-positioned investments. This is not due to an inability to discern the best investment decision but rather due to simply not having enough time to gain the proper know-how. They are under pressure to bring in new clients and retain the old ones. Choosing the best investments for his or her clients is not the priority. To save time, they diversify. However, as one investor stated, "Diversification is protection against ignorance. It makes little sense if you know what you are doing". That investor is Warren Buffett.
This lack of understanding can reduce the FA's confidence to justify purchasing a specific security in a targeted asset class, such as in software technology. In this scenario, the FA relies on third party investment products and/or picks a diversified mutual fund or ETF to do the actual investing work. They distribute the investment money into a number of highly diversified vehicles to spread out the risk. It also clearly illustrates that the FA lacks his or her own investment ideas.
If you have entrusted a financial adviser to invest your money, I urge you to learn how this person invests. If the FA is like the masses of others in the financial services world, third party diversification products is the number one way to invest.
This should concern you. Why? Because you gave your hard earned money to a financial adviser who's main responsibility is to get your money into the coffers of his or her firm - not to make certain that your money is going into the best possible investment opportunity. The financial adviser is under pressure to produce. He or she usually has to meet sales targets to get as much money from people as fast as possible into his or her investment firm. Once the money is had, it is then put into investment products that are a created and even managed by third parties - people that don't work for the financial adviser's firm.
So, you gave your money to your FA who then basically put it into an investment that was created by someone completely unrelated to the FA's firm. Your FA basically outsourced your money.
Ideally, you want your FA to work at a firm that has its own investment ideas and investment products. You want your FA and the people in its firm to be diligently analyzing stock fundamentals, determining their intrinsic value, looking at technical indicators, and deciding if it is time to buy or sell.
You want your FA's main responsibility and mindset to be to put your money in the best investment opportunities, rather than to get as many clients and money into the firm. To illustrate, this financial adviser follows say, a NASDAQ tech stock and is able to recognize its intraday, daily, weekly, and quarterly trading pattern as well as understand how its price is affected by micro and macro economic and industry specific events. This close analysis gives a much better probability to enter into an investment at the right time and know when it's the right time to exit. Again, you want the focus of your financial adviser to be on getting the best return for the client - i.e. YOU - rather than on getting more clients. Does this sound selfish? Well, if your money is at risk, I encourage you to be very selfish and protective.
Also, you want your financial adviser to eat what they cook. That is to say, your financial adviser should be placing his or her money in the same investments that your capital is allocated to. It's a very good test to learn if the financial adviser trusts his or her own investment advice. If the FA does not have his or her funds in the investments that you bought into, I have to ask: why would you invest in something that your adviser isn't completely confident about?
This year, volatility in both the stock market and bond market is expected to continue. The damaging effects of the risk on/risk off trading environment sparked by the Fed's tapering will continue to leave investors on edge. So its important to have an exit plan and be nimble in executing it.
The time-crunched FA will likely go with placing capital in a broad, lumbering, less understood diversified portfolio. It's really the difference between a thoroughly researched and well-timed investment strategy and a spread out investment wager especially when the overall 2014 securities' market environment is not brought into the investment decision process. This leads me to my next point.
2. The Second Reason as to Why Diversification Can INCREASE Investment Risk.
The second reason why diversifying can increase investment risk, especially when handled by that time-crunched financial adviser mentioned above, is thinking that diversification will protect against a massive loss if the overall economy and/or stock market tanks. This may minimize a loss. However, there will still be a loss. Its extent will depend on just how "well" diversified the investments are, of course, but that really equates to shuffling the chairs around on the deck of the Titanic. Everything will go down!
The "multiple egg basket" way of thinking pushes the belief that if you drop one basket, you won't go hungry. However, there is deception with this because investment risk cannot be eliminated 100%. It can only be exchanged, transferred or hedged. With diversification, you are not limiting risk. You are exchanging it.
However, if one is closely in tune with the national and international economies and stock markets, along with what drives the behavior of specific securities, then these major downside market moves will most likely be seen in advance. From this vantage point, it's easy to not only take defensive action, (i.e. exit susceptible investments, but also engage in offensive action via shorting the market, and/or stock(s), or hedging against potential draw-downs). However, the latter approach takes a lot of time and effort to pay attention to the global variables that influence placed-money that expects a return. And, in today's investment environment, particularly the electronically traded one, being well informed and agile can certainly mean the difference between losing money and making money.
So, what I want you to learn from this brief investment note is: diversification is not the best risk reduction method available. And if diversification is done in place of careful analysis, then increased investment risk is the most likely outcome.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: No forecasts can be guaranteed.The views expressed are those of Fifth Capital Management and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.