Diversification is a defensive strategy to minimize your losses in investing by spreading your risk across different sectors. If you lose here, you make up by winning over there, thus minimizing your losses. Experts and brokers advise their clients to diversify their investments, especially in the context of investing in the stock market. This means investing in stocks across different sectors e.g. banking and finance, manufacturing, real estate, commodities etc. The mutual fund is built around this concept. The core of the issue is that you are playing a game of chance since you are not in control and cannot determine outcomes. Not being in control is the hallmark of the amateur investor. You are taking a chance. Since you are not sure, you spread your risks.
Putting it very bluntly, you don’t know what you are doing. If you are sure of yourself, you will focus on a winner and maximize your returns on investment. I find the perspective of Rich Dad quite hilarious and straight to the point. Diversification is like betting on all the horses in a horse race, since you are not sure of the winner. You can never miss the winner if you bet on all the horses since one horse must win. However, your win is minimal, as you have spread your money equally among losers. It is an expensive way of picking the winner.
There is nothing wrong with diversification, if you know what you are doing. There are five major markets namely stocks, real estate, commodities, bonds and currency markets. In the context of diversification, you are not really diversified if all your investments are in the stock market. Even if you spread across all the sectors in the market, you are still in one market. When that market crashes, it takes everything down with it. Every sector may not take a hit in the same magnitude, but when the bears are on rampage, everyone ducks for cover no matter the sector. Folks that diversify in one market always get slaughtered when that market crashes. Diversification does not save you when that market crashes. The wise thing to do is to get out of the line of fire. Exit before the crash. Don’t wait to see which sector is left standing after the crash, if any. If you are investing for cash flow only, then it is a whole new ball game entirely. As long as the cash flow (income from the investment) is not affected, you can ride out the crash knowing that your investment objective is still being met whether the market crashes or booms.
The problem with diversification is that you can easily fall into the trap of becoming a jack of all trades and master of none. In the world of investing, you need to become a master of whatever you are committing your money. You have to take the markets one at a time. It can take years, sometimes more than 5years to master one market. The key is FOCUS.
F – follow
O – one
C – course
U – until
S – successful
Follow one course until successful. (credit financial freedom)
I still believe that real estate serves as a better investment than the stock market for a number of reasons. Most importantly, real estate generally is not as volatile as the stock market. Stocks can plummet for any reason at any time, leaving investors at the mercy of things beyond their control. Global events, such as terrorist attacks, natural disasters, corporate bankruptcy, and high-profile white-collar crimes, can all negatively affect the value of stocks. The reality is that many things can determine the daily value of stocks, far beyond the fundamentals of a company’s financials, which is one of the many reasons Real Estate is still the king.