We have all heard the importance of diversifying your portfolio. However, just like most things in life, it can be done correctly or incorrectly. Here are three mistakes investors make when diversifying their portfolios.
Diworseification = Overdiversification:
The first common mistakes investors make is to over diversify their portfolio. Some investors tend to go overboard and over diversify their portfolio. This can lead to an excessive number of positions that dilute potential returns and make it challenging to monitor and manage the portfolio effectively. The solution here is to make sure that you do not overdiversify your portfolio by getting several professional opinions than making the best decision based on the facts in front of you.
Ignoring Correlations:
One of the main points of diversification is to help mitigate your risk. If you own 1000 ETFs, stocks, and mutual funds that are all correlated than your portfolio really isn’t diversified. The idea is to make sure you consider the correlations between different assets in your portfolio so when one asset goes down, other assets will help offset that decline. If most (or all) the assets in your portfolio are highly correlated, they may move in the same direction during both bull and bear markets, which, in turn, reduces, or eliminates the intended purpose of diversification. Ideally, investors are looking for low or negatively correlated assets which will enhance the effectiveness of diversification. The solution here is to study the correlations between your holdings to make sure they are not highly correlated.
Becoming Too Dependent On Diversification & Ignoring Other Factors:
Another common mistake investors make is to depend too much on diversification and ignore other important factors such as proper research or correlations or broader macro trends. Relying solely on diversification as a risk management tool without conducting proper research on individual investments is a common mistake that can easily be avoided. The best investors (and traders) in the world that I know look at the complete picture before making a decision. They analyze fundamentals, technicals, growth prospects, financial health, and potential risks as well as doing their best to be diversified in non (or low) correlated assets. Blindly diversifying without understanding what you’re investing in can lead to subpar returns and/or unexpected losses. The solution here is to make informed and diversified decisions and not depend too heavily on one tool in your investing toolbox.
Bottom line:
Diversification, like anything else in life, has its pros and cons. When used properly it should complement a well-informed investment strategy rather than replace it. The best investors that I know use it as a tool in their toolbox, but not the only tool.
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