Maybe you’ve heard the saying, “Don’t put all of your eggs into one basket.” If you did that and the basket gets knocked over, then what would happen? There’s a good chance you’d wind up with a lot of broken eggs and very few unbroken ones to use later on. Diversification is the financial solution to making sure you don’t place all of your investments into one place.
Used by businesses and private investors alike, this strategy acts as a form of insurance against large losses. These diversification strategy pros and cons show that when properly implemented, a fairly consistent return can be achieved. Here are the key points to consider.
The Pros of a Diversification Strategy
1. It eliminates the cyclical nature of the standard economy.
Economies grow and economies slow down. When that happens, people change their spending habits. When money is tight, there will be fewer new cars purchased and fewer new mortgages going to home buyers. When money is more available, then luxury items are more likely to be purchased. Diversification allows a portfolio to weather these cycles because a little bit is owned in numerous industries so some things are always up while others are always down.
2. There will always be unpleasant surprises.
A promising medical breakthrough doesn’t happen as expected. The mining company with consistent returns suddenly experiences a collapse at one of their locations. Even leaders such as Steve Jobs can create uncertainty when medical issues affect their performance. The bottom line is this: any investment can be struck by an unpleasant surprise. Being diversified can help to take the sticker shock off of that bad news.
3. Certain investments make diversification easy for the casual investor.
Vanguard is a good example of these. There are four broad ETF options that are available to the casual investor who wants a diversified portfolio. You can go with a total stock market, international stock, total bonds, or a total international bond option. This can help investors stop chasing returns that may have them overlapping their investments more than they intend to do.
4. Diversification helps to maximize the use of potentially underutilized resources.
Sometimes an investment doesn’t perform as it should. It’s just like a business expecting a product to perform one way, but the results which come back show that it performed a very different way. With the right strategy, these under-performing components of a portfolio can be liquidated and then placed into diversified components that do have a proven reputation of success. This allows more money to grow over a longer period of time.
5. Growth is based on the expertise of others.
Although you do need to perform your due diligence to discover what industries tend to be up when others tend to be down, that’s the extent of what the casual investor typically needs to do for work outside of looking at the reliability of businesses. Investors rely on the expertise of others to let their money grow, which means everyone can focus on their core strengths instead of being something they are not.
6. It provides movement away from activities which may be declining.
Sometimes an industry will go down for awhile because of economic factors. Then there are times when an industry will be completely eliminated. After all, when was the last time you went out to purchase a yoke and plow for your livestock? Diversification allows investors to have movement away from activities which may be declining financially so their strategy can always provide them with some form of growth.
The Cons of a Diversification Strategy
1. It naturally limits your growth opportunities.
When investors are willing to take large risks, then they have the potential to experience a large reward. Diversification is a rather conservative investment approach, which means any profit potential is naturally limited. If you are fully invested into a sector of the economy that experiences unusual growth, you’ll have more profits than someone with a diversified portfolio.
2. Even diversification can lose money over time.
Many investors will have bonds in their portfolio to help offset broad declines in the stock market that may happen. The only problem with this is that even municipal bonds, which are about as much of a sure thing as one can get, can lose money if their credit status changes or there are suspicious activities taking place which require an investigation.
3. Some ETF investments for diversification are too diversified.
When asset classes are tracking too many different assets, then the costs of the investment become problematic. Investors need to always be wary of anything that seems to good to be true when looking to diversify. Some alternative mutual funds can perform very well, but using the Vanguard example above, those 4 options aren’t available to retail investors because their costs are so high.
4. There can be unexpected tax complications.
If you’re investing into gold ETFs, for example, then the returns that are received from the buying and selling process are taxed at capital gains rates – at the time of this writing, that was 28%. Other income may only be taxed at the 15% rate or at a 20% rate depending on personal income levels. That’s why the best advice when it comes to diversification is to not invest into something that is not completely understood.
5. It adds complexity to the investment process.
If you have $200,000 to invest, then it is much easier to dump that money into just one investment. If you break it up into 10 investments of $20k each, then you’ve got 10 companies where you’ve got to perform your due diligence. This means that not only is there added complexity to the portfolio, but there are likely going to be added management and bureaucratic costs which must be paid to maintain the investments over the long-term.
6. There can be political and legal influences which change an investor’s life.
Rupert Murdock is an excellent example of this. He became a US citizen in 1985 because non-US citizens were only allowed to own a maximum of 25% equity in any company which held a broadcasting license. His strategy essentially forced him accept citizenship. Although this example is somewhat extreme, the same basic rule applies to all investors. Political and legal influences can be costly in multiple ways.
These diversification strategy pros and cons show that if you want to take a low-risk approach to investing, then this is one of the best options available today. It may limit your growth compared to someone fully vested into a large growth opportunity, but it also means you won’t lose everything should that industry fail out for some reason. Explore how you can be more diversified today and your financial future will thank you for it.
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