One of the most common advice to profit from the stock market is to be diversified by investing in an index fund. While that is not a bad strategy for most investors, for those who want to really build wealth you will need to go against the grain. Diversification is safe and stable, but in exchange, you’re sacrificing outsize investment returns.
In this post, I want to point out some flaws with diversification that are hurting your investment returns.
Disclaimer: None of what I’m talking about should be considered as financial advice. It is only for entertainment and educational purpose only.
Diversification Don’t Build Wealth
Diversification is safe and stable, which makes it an excellent way to preserve your wealth. It doesn’t do as good of a job in building wealth. It’ll help you beat inflation with some gains, which is great, but you won’t be seeing any outsize returns like a 10x.
Okay, so 10x returns are more of an anomaly. Realistically, if you put in the hard work you should be seeing between 50% to 100% return with a low level of risk. That’s significantly better than the 7% return average you’ll get from an index fund.
Attention Split Too Thin
Keeping up with just a handful of companies is tough enough. There is realistically no way for someone to keep up with a portfolio of 30+ companies. Without being able to keep up with the companies you have chosen there is no way for you to make an informed decision to buy or sell more of a company’s stock. As a result, your returns would be around an index fund while you might put in a lot of your time. You would be better off putting your capital into an index fund and do nothing.
Big Returns Don’t Have Much Impact
When you hit a home run where a stock gain at least 100% it is a great feeling. However, that feeling quickly goes away in a diversified portfolio. Having a double up on 2% of your portfolio with the work it takes to pick winning companies is not so encouraging.
To really reap the reward of home run investments you need to have a portfolio of a handful of companies where you have a high level of conviction.
Word of Caution
The process of researching a company then investing in the company and waiting for the reward might seem simple. However, the journey won’t be easy. There will be many hurdles along the way and you’ll be tested countless times. Will you be able to keep calm and not let your emotions take over when your portfolio loses a third of its paper value? Would you be willing to listen to conference calls and keep up with the news for the handful of companies you’ve chosen?
To conclude, there is a time for diversification and that is after you have built up some wealth. Diversification is a great way to protect the wealth you have. However, if you’re just starting diversification will limit your investment returns. Of course, if you’re looking for a passive way to slowly grow your capital then diversification might just be what you’re looking for.
I hope this post was helpful to you. If you found this post helpful, share it with others so they can benefit too.
If you’re new to investing and need a guideline to help you start your investment journey you can check out my post on setting yourself up for financial success. I also have a post about beginner mistakes to avoid in the stock market.
To get in touch, follow me on Twitter, leave a comment, or send me an email at steven@brightdevelopers.com.