Is stock diversification really a good strategy?
Every time the market begins to rise the question that comes under intense discussion is the topic of sector investing and which sector is likely to perform best in the future.
So, why is this?
Because investors are told that they need to buy into different sectors to reduce their risk in order to achieve good returns.
Based on this philosophy, it is about investing in areas that counterbalance those that are likely to underperform, or in other words, when one sector is going down another will go up to balance out the portfolio.
While this may seem like great advice on the surface, when talking to investors who follow this strategy, they claim that while they can achieve good returns in the short term, they achieve very poor to average returns, at best, over any ten year period.
So, this begs the question as to who this type of investing really works well for.
While it’s likely that this form of portfolio construction benefits the industry, it is not very beneficial for investors as they typically end up holding 25 to 40 stocks in their portfolio.
When I see over diversified portfolios like this, it is very common to find that one third of the portfolio is rising while the remaining stocks are going down or sideways.
I refer to this as 'diworsification', given that a portfolio that is over diversified is exposed almost exclusively to market risk, which is why many investors end up achieving very mediocre returns.
In my opinion, you should spend less time worrying about which sector to invest in and spend more time looking for good stocks, because smart investing is about buying what goes up and selling what goes down.
Dale Gillham is Chief Analyst at Wealth Within and international bestselling author of How to Beat the Managed Funds by 20%. He is also the author of the award-winning book Accelerate Your Wealth—It’s Your Money, Your Choice, which is available in book stores and online at www.wealthwithin.com.au