Diversification is a fundamental principle of investing, but it isn’t the only one. In fact, there is one major principle that precedes it: make sure you own financial products that have a reasonable expectation of providing a useful return and serve the purpose of your goals.
Sometimes, the best financial task is not to “just” own a diversified portfolio; it’s to avoid owning bad investments. Don’t sacrifice your portfolio at the altar of blind diversification. Every investment should stand on its own merits, as well as work with your other assets to make them function better.
Many times, “diversification” becomes an excuse for financial institutions to sell you crap and get paid for underperformance. For example, your advisor may have sold you a “well diversified” portfolio holding U.S. stocks, emerging markets, commodities, and corporate bonds, which means that you are invested into multiple asset classes that would all be expected to go up in a growth environment. The fundamental problem with such a portfolio is that while it’s spread out across several different asset classes, it is very poorly diversified, because the portfolio just owns multiple asset classes all aligned towards the same risk – benefitting if the economy grows, and at risk if a recession occurs.
To do it right, you must take a closer look at the returns of each fund that you own to make sure it is performing better than its peers. You also need to make sure that there isn’t a lot of overlap in the fund that would contradict investments in the other classes.
Furthermore, you have to consider the weighting and risk category of each class that you have in your portfolio. In any given year, each asset class is going to produce different returns. Basically, you want to have the right fund in the right class at the right time to garner the greatest returns for your level of risk.
You see, there is a lot more to “diversification” than you might think. You can’t allow yourself to get sold a poor financial product just so that you can say that you are diversified!
The purpose of the money ALWAYS dictates where you should put it. That means that you might earn a lower rate of return on a certain asset class but that is okay because its role may dictate it.
Some of your investments may serve as a hedge against a declining market. Their performance may lag in a strong bull market but that doesn’t mean you shouldn’t include them in your portfolio. Savings accounts hardly pay any interest, but you must have liquid money for emergencies and to make asset purchases when they go on sale.
The problem with buying investments that do not meet your objectives is that there is no meaningful way to track how their performance helps meet your objectives. For example, purchasing an annuity with a great income rider doesn’t help you if you don’t really need extra income or specifically need “tax-free” income. On the other hand, it might be the perfect choice if you want a guaranteed income source in the future.
So, make sure to purchase financial products that provide reasonable returns that serve a purpose in your portfolio, as well as potentially make your overall situation better.
There are no excuses to own bad investments just for the sake of diversification.