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Building wealth with portfolio diversification

Looking to get started with building wealth? In this article, we'll explore how portfolio diversification can help you reach your financial goals.

Who would have thought that 17th-century Spanish literature could have such a dramatic effect on the global investment community? Who would have thought a classical book Don Quixote, could inspire an idea that is so entrenched in the investment vernacular as to drive the way we shape and view our investment portfolios? The author of the book Miguel de Cervantes, is widely recognized as the first to write,

 “It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”

Having all your eggs in one basket implies a high-risk strategy. If the basket falls, the eggs will break. This metaphor is one of the top clichés for investors. If all your investments are in one asset class or one investment this could have drastic consequences on your portfolio.

In this article, we examine why diversification is a favored investor strategy, the different types of diversification, and a contrary opinion from one of the world’s greatest investors that will surprise you.

Why is Diversification a favored strategy?

When you decide to create an investment portfolio, you soon realize you are in the risk business. Your underlying portfolio objective is to carefully maximize returns against the risks you feel comfortable taking.

We all have different levels of risk tolerance

Your risk tolerance depends on so many factors, including.

  • your knowledge and experience of an asset,
  • your preferred timescale
  • your age.

If you are a 25-year old digital native, you are more likely to feel comfortable with riskier technology assets in your portfolio. You understand technology and if it goes wrong you can make up ground later.

As a retiree investor, you are more likely to need stability and income-generating assets to provide you with ongoing income, such as real estate assets.

Risks and returns vary

Global investors salivate at the average annual real return (adjusted for inflation) of 7.3% for the equity markets over the past 30 years. It becomes the benchmark by which we judge other investments. There are, however, certain assets that come along that are outliers with performances that almost defy gravity.

Bitcoin has been one of the strongest-performing asset classes since its launch in 2009. From a standing start, Bitcoin generated an average annualized return of 1,576% over the years 2010 – 2021. To put this into context Good Financial Cents compared Bitcoin’s returns over the period 2010 to 2021 to more established investment assets that themselves provided very strong returns.

 

 

Of course, it’s easy to be an armchair investor with 20-20 hindsight, but as investors we have to crystal ball the future, to make sense of where future returns are likely to come from, and the forces that might undermine those returns.

Riskier assets tend to be highly volatile

Bitcoin’s journey has been bipolar. Like any asset, when we look at Bitcoin in the interim years there are challenges. In 2021, Bitcoin peaked at $67k falling to $18k in 2022 –  a jaw-dropping 73% decline. Bitcoiners flippantly recognize this as “just part of its cycle” – with returns falling by 58% in 2014 and 73% in 2018 respectively. Volatility brings much greater risk.

Imagine you had placed your life savings into Bitcoin at it peak price of $67k when even Financial Institutions were suffering from FOMO (fear of missing out) to see its value plummet to $18k. That’s a lot of broken nest eggs.

Balancing your Portfolio

Many investors use diversification strategies to balance a portfolio against volatility and risk. The core idea is that different assets do well at different times and that by balancing your portfolio you reduce the overall risks of your portfolio. A very popular balancing structure is the 60/40 strategy.

Under this strategy, 60% of your portfolio is placed into stocks and 40% into bonds. In this way, you get the best of two worlds: the potential for high growth from riskier stocks and some protection from the more conservative bonds. Many investors further diversify their stocks, ensuring they are in different industries to minimize the risks of adverse forces undermining any one industry.

This balancing strategy is usually adjusted according to your individual risk tolerance and the asset classes you feel comfortable with, and income-earning assets like real estate. This Forbes article highlights a number of portfolio ideas to consider, with one example that blends the average of Harvard, Stanford, and Yale’s investment allocations:

 

 

How does Warren Buffet view Diversification?

Warren Buffett has a very different take on diversification. In many interviews, he has said

“Diversification is protection against ignorance.”

He argues that diversification can actually damage returns because you can only hold a few strong investment ideas at any given time. Broadly, his thesis is that if you:

  • fully understand the company you want to part own,
  • appraise all the necessary risks and believe with conviction in the investment,

you can generate higher returns. While his views are contrary to traditional risk management, his track record, of course, speaks volumes.

It is noteworthy, however, that he is not a fan of technology, once alluding to Bitcoin as Rat Poison, and his investment firm, Berkshire Hathaway does have 53 stocks in its portfolio – so this probably reflects his personal investment views and should be viewed cautiously when assessing your own portfolio management.

Perhaps Mark Twain should have the final word on diversification, when in his book Puddin’head Wilson (1894) he wrote:

‘Scatter your money and your attention; but the wise man saith, ‘Put all your eggs in the one basket and—WATCH THAT BASKET.’

While recognized as a humorist and a writer, perhaps Mark Twain was the inspiration for Warren Buffet’s investment strategy all along.

Funny stuff this investing…

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