Are There Any Reasons to Diversify?

Many financial gurus often advises that diversification is used by people to protect themselves against their own ignorance. They noted that if you know what you are doing, you should concentrate your portfolio into equities as they achieve the highest return. And you can achieve low risk not by simply spreading your money around, but by your competence of knowing which funds and stocks to pick. In fact, if you have read the latest chapter of Conspiracy of the Rich by Robert Kiyosaki, there was a paragraph that goes:

‘If you listen to most financial pundits, they will always say that smart investors diversify. Yet, to quote Warren Buffett in The Tao of Warren Buffett, “Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”‘

If this investment concept was preached years ago, well, probably the financial gurus are right!

Let’s look at the unimaginable market of today!

General Motors (NYSE:GM) and Citigroup (NYSE:C) are slated to be removed from the Dow Jones Industrial Average (DJIA) and will be replaced by Travelers Companies (NYSE:TRV) and Cisco Systems (Nasdaq:CSCO).

Today, we are talking about the removal of these two global giants from the DJIA. In fact, GM is filing for Chapter 11 bankruptcy right now!

How Does Chapter 11 Affect My Stock Holdings?
The liquidation of a company and the zeroing out of a stock typically happens when a company files Chapter 7 bankruptcy. Unlike its bankruptcy filing sibling, Chapter 11 bankruptcy – announced by General Motors on June 1 – allows a company to carry on with its operations while it transforms into a leaner version of its previous self. The Securities and Exchange Commission makes it clear that in most Chapter 11 cases the company’s plan of reorganization will cancel the existing equity shares. This is the reason investors should remember their place in line behind secured (banks) and unsecured (bondholders) creditors who stand to be repaid first before common stock holders.

Well, Should I diversify?
In today’s market, most unit trust agents, insurance agents or financial planners in Malaysia and Singapore have a common saying, “You must diversify and invested in many different funds. Once you have done that, just hold it because mutual funds is a long term investment!”

The sad reality is, while you are technically diversified into several funds, you are not diversified because you are invested only in several asset classes. Worst still, because of broad diversification, as you minimize you risk, you are minimizing your potential returns as well!

So, What’s the point?
Well, my point is that we may use the same words but speak a different language. To some, diversification means investing in different mutual funds and hoping that their risks are spreaded out. A mutual fund by definition is already diversified, it is a fund made up of a diversified group of stocks. A mutual fund is like buying shoes. Buying a same brand and same style of sport shoes in 3 different color doesn’t mean that it suits corporate dressing!

What are the principles behind minimizing risk and achieving excellent returns?
The right answers are still up for debate, but I’m comfortable with the 6 Golden Rules of Investment
1. Consistency instead of Volatility
2. Proper Asset Allocation
3. Focus Diversification instead of Broad Diversification
4. Capital Preservation
5. Stay Invested Despite Market Shocks
6. Value Averaging

Now that you have learnt that broad diversification is a protection against ignorance and yet there is a need for a Focus Diversificaton strategy, strap yourself in this blog as I’ll be soon sharing in details ways to construct a growth strategic investment portfolio with the 6 Golden Rules of Investment!