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The Myth of Investment Diversification & Why Mutual Funds Are Bad

By Kiara Ashanti

diversificationWhen it comes to the tenets of proper investing and personal finance, some rules have been discussed so often that even non-experts know them: Do not get deep into debt, save money for a rainy day, buy life insurance, and do not try to day trade. There is one rule, however, that is considered the granddaddy of all investing maxims: Diversify your investment portfolio. Or as the saying goes, “Do not put all your eggs in one basket.”

But let me ask you a question: What if all the people who say to diversify are actually wrong?

The Birth of Investment Diversification

The idea that you should not put all your eggs in one basket may be a common sense rule. But ironically, most investors prior to the 1980s not only did not follow it, they were not even encouraged to do it. In the 1980s into the 1990s, the popularity of 401k plans, IRA accounts, and the record number of middle class Americans entering the stock market helped push the idea as a marketing concept to sell mutual funds.

In the ’70s and ’80s, investing in the stock market meant buying stocks – that was the realm of the affluent and the wealthy. Main Street America could not afford the stock commissions of that era. No, mutual funds were the only way the average American could get in on the growth potential of the stock market.

One-hundred dollars would not buy you many shares of IBM – not after commissions. However, allocating $100 each month into a mutual fund was something a working class American could do – that was one major selling point. The other was a mutual fund’s diversified setup. It was a perfect selling tool: $100 each month buys you an investment in many companies, but if one goes down, your risk is spread out. Therefore, in a downturn, you cannot get hurt as badly.

This proved to be a sound sales pitch – and as many people who had money in the market during the dot-com bubble burst in 1999 and the end of 2008 can tell you, not true. Diversification, in theory, is perfect, but in reality there is a price to pay.

diversification

Watered-Down Returns

Imagine the perfect glass of iced tea: It has the right sweetness and a perfect hint of lemon. Now, imagine if you mixed the glass of tea with a gallon of water. Do you want to drink some now? That, in a nutshell, is a mutual fund.

Mutual funds suffer from over-diversification. Regulations cap the money a mutual fund can invest in any one company: Under the Investment Company Act of 1940 that governs mutual funds, a fund cannot have more than 25% of its holdings in any one security. The other 75% must be divided among at least 15 different securities so that none of them represent more than 5% of the total fund. Furthermore, none of those 15 securities can own more than 10% of the stock of any one company also owned by the mutual fund company.

This means that any positive growth in the upside of the market will happen at a slow pace. There is not enough money in one stock, or even a few stocks, to fuel fast growth (profits). That does not protect you, however, from the downside.

As many banged-up retirement funds can showcase, the large diversification of the fund does not protect you from sharp declines in the market. A mutual fund that has 20 companies in their fund is still in the market. Large downturns in the stock market, such as the one the country experienced in 1999, affect the whole market. Therefore, every single stock in the fund goes down, and the mutual fund goes down too.

The rule of the market is that downturns happen more sharply than upswings. This means you get slow upside growth and rapid downside losses.

diversification waters down your investments

The Richest People Are Not Diversified

Bill Gates, Warren Buffett, and Michael Dell: What these three famous entrepreneurs have in common is not just their billionaire status – it is that none of them are diversified (or, at least, not greatly). Their extreme wealth is the result of holding stock, primarily in one company.

It is true that they own the stock of companies they founded and ran, but they are a perfect illustration of the power of concentration. The quickest and the fastest way to wealth is when you own concentrated positions. When the market moves, you make the most money when you own many shares in one or a few positions, as there is more leverage with concentration.

The flaw in this strategy is that when the market goes down, you will lose a lot more. However, there are strategies available to mitigate such losses – including having a portfolio that is truly diversified and not just invested in a range of stocks, and using financial derivatives like options to protect against market downturns.

The point here is that no one will come close to Gates or Buffet, investing $100, $200, or even a $10,000 dollars a month into a mutual fund. There is not enough concentration in the fund, and your returns will likely reflect that.

Effective Diversification

Your mutual fund gives you the illusion of diversity. The only true ways to be diversified are to have money invested in different types of security classes, or to a lesser extent, different sectors. In other words, to be truly diversified, your investment needs to be spread out among stocks, bonds, gold, currency, and commodities. If you are not doing that, then you are not diversified.

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Final Word

Fear of loss is the main reason why most people accept the rule of diversification. No one wants to lose money, not even Warren Buffet. His number one rule of investing is don’t lose money. His second rule is don’t forget rule one. It is a cute line, but the rub is in how to do it.

History has shown that diversification has not saved many portfolios. In fact, the way it is practiced today makes it more likely, not less likely, that you will take a substantial loss at some point. The truth is that you cannot avoid losses. You will take losses at times in your investments, whether they are diversified or not.

The trick is in not losing too much, or too often, and doing that can be simple. Through the use of effective diversification – money invested in stocks and a little in something the opposite of stocks, like bonds, or using covered calls – you can lower the risk to your investment portfolio a great deal.

What tips do you have for reducing your investment risk?

(photo credit: Shutterstock)

Kiara Ashanti
Kiara Ashanti is a former financial advisor, securities trader, and writer in Central Florida. He has written for Black Enterprise Magazine, Active Trader Magazine, and Atlanta Post, and has even appeared on The Oprah Winfrey Show. Kiara covers the areas of business, investments, and personal finance.

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Comments

  • Kurtis Hemmerling

    Nice article that strikes at the heart of Modern Portfolio Theory. The concept is rooted in this idea that volatility is risk…but not necessarily. A $100 stock that pays out $50 per share as a one time special dividend will see prices fall in half. If the company is rock solid – you could have an incredible yield based on basement level PE ratios. Another company might climb with little volatility over years but be WAY overvalued. Which is lower risk? Is volatility a good metric in this instance? In essence MPT is suggesting that past performance (or volatility) dictates future performance (or risk). Guess they forgot to read that disclaimer.

  • Ken Faulkenberry

    Lack of attention to valuation and overdiversification are the two mistakes that are destroying portfolio returns. Thanks for excellent read!

  • This Article is Silly

    Honestly, diversification with or without mutual funds is not an illusion. I guess your trying to say that a mutual fund in itself does not create diversification in regard to an asset allocation if its just invested in stock (or at least that’s what I am getting from your article). Well all I have to say to that is DUH. Seriously, the lay man is gonna read this article and take away 2 things that mutual funds don’t diversify (which is wrong) and you should be like bill gates and own one stock. Now the truth is a stock fund in a bad stock market will more then likely go down (I know a real shocker). If you are properly diversified in the first place meaning you have bonds and short term reserves (cash) then that doesn’t matter one bit. Stocks aren’t meant for freaking short term investments but long term growth. If your 80 and have 100% in a stock fund then subsequently lose 50% because the stock market went down 50% well what were you expecting? I know there are people that sell crap to older people to take advantage of them but at some point people have to try and understand what they are putting there money into. I really don’t get this “The rule of the market is that downturns happen more sharply than upswings. This means you get slow upside growth and rapid downside losses.” Who’s rule is it? Yours? Over-diversification isn’t what kills peoples returns you goof its the fact that they invested all there money in one asset class and subsequently sold when the market went sour. Or possibly the fact that said investment us expensive from a cost stand point. Oh and I’m going to say this regarding Bill Gates or others that did well by investing in one company its called luck. Yup they put all there money on red during a game of roulette and won good for them. That is not a sound strategy for investing for the public though (again big surprise). The general lay man should not be using derivatives they are complex and can be expensive. Oh and finally about the lack of attention to valuation… you can take your PE ratio’s and shove em I DON’T CARE ( I guess that kind of validates the fact that I don’t give em attention haha). I don’t try and find the best investment I simply look for low cost investments and that’s it. You may find your wonderful dividend stock stops paying (yes this happens a lot during recessions) then what? Or maybe you got that great steal of a price on your stock because it was undervalued then uh oh the market goes down and you lose every bit of profit you gained (on paper at least). Can you predict whats going to happen? No? Then I don’t care.

    • Kashanti

      Luck is usually the reason people give for the success of others in areas where you have not been as successful. Re-read the article. I think you are missing a couple of points that I made. namely that mutual funds have TOO much diversification, and adding a bond fund does not itself cancel that out.

  • http://www.manhattansgreatest.blogspot.com/ jim

    Interesting post on investing its always important to rebalance your investments from time to time.

  • http://www.seeitmarket.com/ Andrew Nyquist

    Enjoyed your Final Word. Investors have to dig in a bit and do some homework. Learning is freeing… ;-)

  • http://twitter.com/FinancialTales Carlos Sera

    I completely agree with this article. I recommend reading A Practical Tale and A Tale of Might. They expand on the Myth of Diversification

  • James Hendrickson

    Kiara,

    An interesting article. I would say that you tend to overlook Modern Portfolio Theory.

    That said, I think you are correct about the self serving nature of the finance industry.

    Best,

    James

  • http://www.pipstoday.com/ Shawn James

    Hi Kiara, Thanks to share such good article with us. I have invested money in stock, forex and mutual fund, here I am shocked when I see “Why Mutual Funds Are Bad”, according to me, many people’s always chose first choice is safe side they know it’s return fixed. I am agree diversification is key to reducing investment risk but we don’t forget all investments have risk.

  • Andrew

    Diversification may do good to your investments, however over-diversification can prove to be a threat to your wealth. Great points, thanks.

  • Jay Aspenwood

    Great points about (over-)diversification, Kiara. The idea behind diversification is, as we all know, to mitigate the risk of unforeseeable negative impact on any single investment. Therefore the degree of diversification depends much on the type of investments you are making and your ability to understand them. If you invest in something very stable, and something you understand and can directly control (to an extent), your need for diversification is low. If your investments are very volatile and you either don’t have deep understanding of their fundamentals or cannot much control them, you probably want to diversify much more.

    A big majority of mutual funds are poorly managed and focused on making money for the fund management company and fund managers, rather than their customers. They aim to get near the market returns and own the same shares as everyone else, as this will make sure they usually fall only a little behind the market returns. They’ll run with the herd, as they hate the idea of getting the blame for doing something different and then potentially failing with it. Diversification to the point where they pretty much own all major shares of their benchmark therefore makes perfect sense for them.

    Luckily, we don’t have to join their game or be their customer. If all we are shooting for is market returns, owning an index fund is the logical solution. And if we want something more, we have many great alternatives: pick our own stocks (as few or many as makes sense to us), invest in real estate, start our own businesses, or anything else that we understand and can control. When we really understand our investments and can directly control their risks, there is no need to dilute our profits through over-diversification.

  • Tortoise Banker

    I have to disagree. I think most Americans would best be served by picking a target date retirement fund from a low-cost investment company like Vanguard or Fidelity.

  • Greg

    “Diversification is for those who don’t know what they are doing.” –Warren Buffet

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