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I always hear people telling me things like:

Diversifying your stock/investment portfolios helps ensure more profits/success.

It's common to diversify portfolios (usually this is said with no exact reasons given).

Diversifying your portfolio helps save you money

Above all, can anyone explain to me how:

1.Diversifying investments can help me profit more.

2.How it may or may not help more cut my losses.

3.How it's any better of a strategy than ... well ... not doing it.

I can't seem to fathom how just diversification alone will help me profit.

What's the gig with diversifying an investment portfolio, and why would I care for it vs. just investing and trying to profit in general? It's almost like it's preached, but without solid reasoning.

For example, if I just want to profit, why would risk tolerance matter? And how would diversifying anything help cut my losses/etc.? I'm genuinely interested in the logic here.

I am a short-term investor (i.e., I believe in making gains quickly; not holding anything too long).

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Basically, diversifying narrows the spread of possible results, raising the center of the returns bell-curve by reducing the likelihood of extreme results at either the high or low end.

It's largely a matter of basic statistics. Bet double-or-nothing on a single coin flip, and those are the only possible results, and your odds of a disaster (losing most or all of the money) are 50%. Bet half of it on each of two coin flips, and your odds of losing are reduced to 25% at the cost of reducing your odds of winning to 25%, with 50% odds that you retain your money and can try the game again. Three coins divides the space further; the extremes are reduced to 12.5% each, with the middle being most likely.

If that was all there was, this would be a zero-sum game and pure gambling. But the stock market is actually positive-sum, since companies are delivering part of their profits to their stockholder owners. This moves the center of the bell curve up a bit from break-even, historically to about +8%. This is why index funds produce a profit with very little active decision; they treat the variation as mostly random (which seems to work statistically) and just try to capture average results of a (hopefully) slightly above-average bucket of stocks and/or bonds.

This approach is boring. It will never double your money overnight. On the other hand, it will never wipe you out overnight. If you have patience and are willing to let compound interest work for you, and trust that most market swings regress to the mean in the long run, it quietly builds your savings while not driving you crazy worrying about it. If all you are looking for is better return than the banks, and you have a reasonable amount of time before you need to pull the funds out, it's one of the more reliably predictable risk/reward trade-off points.

You may want to refine this by biasing the mix of what you're holding. The simplest adjustment is how much you keep in each of several major investment categories. Large cap stocks, small cap stocks, bonds, and real estate (in the form of REITs) each have different baseline risk/return curves, and move in different ways in response to news, so maintaining a selected ratio between these buckets and adding the resulting curves together is one simple way to make fairly predictable adjustments to the width (and centerline) of the total bell curve.

If you think you can do better than this, go for it. But index funds have been outperforming professionally managed funds (after the management fees are accounted for), and unless you are interested in spending a lot of time researching and playing with your money the odds of your doing much better aren't great unless you're willing to risk doing much worse.

For me, boring is good. I want my savings to work for me rather than the other way around, and I don't consider the market at all interesting as a game. Others will feel differently.

keshlam
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  • Also some sectors geographic areas don't move in lock step with other for example a few years ago commercial property was out of favor buying them would have performed better than just a FTSE100 tracker – Neuromancer Apr 21 '18 at 20:42
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Diversifying is the first advice given to beginner in order to avoid big losses. For example in 2014 the company Theranos looked really appealing before it failed in 2016. So a beginner could have invested ALL his money and lost all of it. But if he had diversified he wouldn't have lost everything.

As an investor goes from being a beginner to being experienced, some still diversify and others concentrate. Mostly it depends how confident you are about an investment. If you have 20 years of experience, know everything about the company and you are sure there will be profit you can concentrate. If you are not 100% sure there will be a profit, it is better to diversify.

Diversifying can also be profitable when you lose money: because you will pay tax when you earn money, if you diversify you can choose to lose money in some stock (usually in December) and in this way cut your taxes.

Flux
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Dupond
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Any investor can make a bad bet, even Buffett. Even if you have done every bit of research on an investment possible you are exposed to random external events.. acts of god, and outright fraud.

fendermon
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Diversification is used by many to hopefully reduce the risk when bad investments are made. Diversification does not help you make more profits but instead averages down your profits.

There is no way one can tell whether a stock or portfolio of stocks will go up or down once they are purchased. In order to try to provide some protection against total loss of the portfolio, a lazy so called long term investor will use diversification as a way of risk management. But the best outcome for them will be an averaging down of their profits.

A better method is to let the market tell you when your purchased investment is a bad one and get out of that investment early and thus limiting your losses, whilst letting your good investments (as determined by the market) run and make larger profits.

Victor
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    Remember that Enron, Lehman, Madoff, and Ponzi looked like good investments until they quite suddenly didn't! – MD-Tech Jan 04 '17 at 10:00
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    @MD-Tech - and if you listened to the markets you would have had many chances to get out before it was too late. But those who bought and held them would have ended up with very little. – Victor Jan 04 '17 at 10:08
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    Why do you say that it 'averages down' your profits instead of 'averages up' your profits? You are assuming that the 'first' investment choice is the good one, and the subsequent investment choices are bad ones. – Grade 'Eh' Bacon Jan 04 '17 at 13:37
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    @Grade'Eh'Bacon - the whole point of diversification is to try to buy uncorrelated assets in the hope they will not all go down at the same time. By doing this you will be including some assets that are less risky and thus will have lower returns. You will also be trying to buy assets that will tend to go up whilst others go down and vice-versa. You will never maximise your returns in this manner. Also, I am not assuming anything, as I said in my answer the better way is to let the market decide which trades are winners and which are losers, and if losers simply get out of them early. – Victor Jan 04 '17 at 22:17
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    Maximizing instantaneous return, and maximizing long-term return, are very different things. There is always a risk/reward trade-off, with many correct answers depending on the individual investor's needs and tolerances and timeframe. – keshlam Jan 05 '17 at 01:13
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    @keshlam - it is not about instantaneous returns but rather about holding on to a losing investment just because you convince yourself it is part of a diversified portfolio. If it is crap get rid of it before it does become an Enron and Co. – Victor Jan 05 '17 at 08:28
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    @victor: "Holding on to a losing investment" presumes that you can predict that the investment will not recover value strongly enough or soon enough to make continuing to hold it worthwhile. Without that ability to project, you risk getting into buy-high-sell-liw mode, which is of course the opposite of what you want. If you know your stocks deeply enough that you think you can reliably move the money to a place where it will do better, more power to you. I don't believe I can predict whether most dips and surges are short-term or long-term, nor that I can time the market that way. – keshlam Jan 05 '17 at 14:30
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    @keshlam - simple definition: uptrend - higher highs and higher lows; downtrend - lower lows and lower highs. Applying this you would buy when price is in an uptrend and sell when the uptrend ends. No prediction required, you just listen to what the market is telling you. If an uptrend ends and you sell then a few months later a new uptrend begins then you can buy back in again - simple!!! Yes you might pay a little extra in brokerage and maybe a little bit of tax, and maybe even make a small loss - but that is much better than it turning out to be an Enron and you lose your whole investment. – Victor Jan 06 '17 at 01:08
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    The first rule of investing should be to preserve your capital. There are simple techniques you could learn that can provide early warnings that a stock may be in trouble, it has nothing to do with predictions nor listening to the daily white noise of the news - it is simply the actual price action and whether the stock is currently uptrending or downtrending, and for long term trends you can determine this from weekly charts. – Victor Jan 06 '17 at 01:16
  • @MD-Tech not really some of my active funds in the UK dumped banks before the crash – Neuromancer Apr 21 '18 at 20:43