Diversification is eating into your returns
Don’t over-diversify; do this instead
Take a peek at your portfolio. Go ahead, I won’t look. OK, now, here’s what I need to know: Do you see a collection of stocks you’re proud to own? Are they companies you believe in? Are they companies you can see yourself rolling with long term? How much did diversification factor into your decision to buy them?
If you love ’em all, great. You’re doing things right. Always, always, always, invest in what you know. If you don’t understand a specific company’s business model, or enjoy a product or service they offer, why the heck would you invest your hard-earned cash into it?
Now, for you the rest of you … don’t freak out if you see a few stocks you don’t necessarily love. I’m sure some are just hanging around for diversification. If you’re new to investing, and haven’t quite pinned down your game plan, I’m sure you’ve stumbled upon more than a few people urging you to do just that. Don’t sweat it. I’m sure your investment app allows free trades. Cut the dead weight and save all your investing dollars for stocks you actually want to own.
Diversification isn’t inherently terrible
Diversification isn’t necessarily a terrible idea on its own. The implementation, though, is what starts to create problems. For example, if you care about the planet — and you better care about the planet — don’t invest in dinosaurs like Exxon of Chevron just because they pay good dividends or add a company from the energy sector to your portfolio. There are plenty of clean energy stocks out there to scratch that itch (NextEra Energy, Plug Power, etc.). There are even more that pay dividends.
Still, what do you know about NextEra Energy or Plug Power? If the answer is nothing, or next to nothing, don’t invest in the company … at least not until you do your own research. Find out how it makes money, how much debt it has and how it invests its capital. Then, find out how it plans to compete in the future. If you believe the story, and think it’s worth buying in, by all means, buy in.
But don’t go overboard.
The downside of diversification
Stated bluntly: the opportunity cost created by diversification could be killing your returns. I could spend thousands of words talking about the pros and cons of diversification, but that’s been done before. Plenty of bloggers already beat me to the punch on the topic and, well, I don’t think young investors need to know many of them anyway.
What stands out most to me, and will likely prevent me from ever owning any more than five stocks at a time (I never say never, but …) is opportunity cost.
For example, I love Microsoft as a long-term play.
That said, if I have a choice to buy Microsoft or an energy giant like Exxon, I’m buying Microsoft every … single … time. I don’t care Exxon has a P/E ratio of 10 and a dividend yield of 3.59%. I don’t care that it’s printing money hand over fist as inflationary pressures are pumping up profits, either. You don’t invest in big oil, you trade it. If you’ve held for the last five years, you’re up (minus dividends) just under 20%.
If you invested more of the money you spent on Exxon in Microsoft, though, whatever you put into Microsoft five years ago would be worth almost 200% more today. It’s not even close, people.
Microsoft’s five-year chart
Exxon’s five-year chart
That 180% difference is opportunity cost.
All I’m saying is this: Don’t worry so much about diversification. Instead, worry about identifying stocks you want to own for the long term and invest all the discretionary income you can into them.
Disclaimer: I’m a market participant, not a financial advisor. This is not financial advice.
