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Three Mistake Investors Commit When Diversifying Their Portfolio

NEW YORK, NY, OCTOBER 15: On October 15, 2014, in New York City, a trader works on the floor of the New York Stock Exchange (NYSE).

As fears of Ebola and a global economic slowdown spread, stocks plummeted on Wednesday, with the Dow plummeting more than 400 points before recovering. (Image: Spencer Platt/Getty Images)

We have all heard about the importance of portfolio diversification. However, as with the majority of things in life, it can be done properly or improperly. Here are three common diversification errors made by investors:

Overdiversification = Diversification:

Excessive portfolio diversification is the most common mistake investors make. Some investors have a tendency to over-diversify their portfolios. This can result in an inordinate number of positions, which dilutes potential returns and makes it difficult to effectively monitor and manage the portfolio.

The solution is to ensure that you do not over-diversify your portfolio by soliciting multiple professional opinions rather than basing your decision on the available data.

Ignoring Relationships:

One of the primary purposes of diversification is to reduce risk. If you own 1,000 correlated ETFs, equities, and mutual funds, then your portfolio is not diversified.

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The goal is to ensure that you take into account the correlations between the assets in your portfolio so that when one asset declines, other assets will help to mitigate the loss.

If the majority (or all) of your portfolio’s assets are highly correlated, they may move in the same direction during both bull and bear markets, which reduces or eliminates the diversification benefit.

Investors should ideally seek out assets with low or negative correlation, which will increase the efficacy of diversification. Examine the correlations between your holdings in order to ensure that they are not highly correlated.

Too Much Reliance On Diversification And Ignoring Other Factors

Another common error made by investors is relying too heavily on diversification while ignoring other important factors such as research, correlations, and macro trends.

A common error that is simple to avoid is relying solely on diversification as a risk management tool without undertaking adequate research on individual investments. Before making a decision, the finest investors (and traders) in the world that I know consider the entire picture.

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They analyze fundamentals, technicals, growth prospects, financial health, and potential hazards, in addition to diversifying as much as possible among non-correlated (or low-correlated) assets. Diversifying blindly without understanding your investments can result in subpar returns and/or unanticipated losses. The solution is to make informed, diversified decisions and not rely excessively on a single investment tool.

Conclusion

Diversification, like everything else in life, has both advantages and disadvantages. When used properly, it should complement a well-informed investment strategy rather than replace it. The greatest investors I know utilize it as a tool, but it is not the only tool in their toolbox.

Reference

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