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Diversification vs diworsification: Balancing concentration when investing

April 17, 2024
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Balancing equity allocation in your portfolio.

In school we are all told to focus on one thing that makes money, go study and specialize in some area as the world seems to reward specialization. Yet when it comes to investing, we often get told to invest in a broad well-diversified portfolio. Kind of contradicting right?

In this article, we will have a look at what the difference is between these two. What is the reason for people to recommend their actions and when does it make more sense for each recommendation to be used.

 

What is diversification?

Diversification is a strategy founded by Harry Markowitz for managing risk by investing in a variety of assets that are not close or uncorrelated with each other. The idea is that if one asset loses value, the others may not, and the overall portfolio will still be protected. This helps to minimize the impact of any one investment on the overall performance of the portfolio. Diversification can also refer to spreading investment across different industries, sectors, or geographic regions. In the investment world, it's called the only free lunch, but is it?

 

What is diworsification?

Diworsification is a term coined by Peter Lynch used to describe the opposite of diversification, where an investor spreads their assets across too many investments, resulting in a portfolio that is less efficient than it would be if the assets were more concentrated. As a result, the portfolio may not perform as well as it could have if the assets were more focused on one asset class.

 

Which one is for you?

In the book The psychology of money, Morgan tells us that Harry Markowitz did not follow his investment philosophy and that the son of the most famous passive manager, Mr. Bogle, became an active fund manager. We also heard that Warren Buffett's mentor, Benjamin Graham, got lucky when invested in Geico Shares even though it did not suit his philosophy. People tend to do things that are rational for them and don't always follow their advice.

Whether you should diversify your money or focus on one asset class depends on your investment goals and risk tolerance. If you aim for maximum growth, you should concentrate more on equities. If you're looking for more stable returns, then start diversifying. Easy right?

Diversification can help to manage risk by spreading investments across a variety of assets such as stocks, bonds, real estate, commodities, etc. Which reduces the volatility of your portfolio and provides a more stable return over the long term. The portfolio can provide better returns in bear markets (decline in stocks) and worse performance in bull markets (stocks going up) 

On the other hand, focusing on one asset class can potentially lead to higher returns if that asset class performs well. However, it also increases the risk of the portfolio as the performance of the portfolio will be highly correlated to that asset class. In this strategy, time in the market is your only friend.

Ultimately, the right strategy will depend on your circumstances and risk tolerance. It is recommended to consult a financial advisor or investment professional to design an investment plan that aligns with your goals and risk tolerance.

 

Examples of scenarios

During the financial crisis of 2008, specifically the year 2008, the JSE ALSI index dropped by 23.23%. Yet, bonds, represented by the average of the interest-bearing variable term sector, increased by 14.97% during the same period. An investor with a diversified portfolio of stocks and bonds would have experienced a much less severe loss than an investor with a portfolio focused solely on stocks.

During the following year 2009, the JSE ALSI index increased by 32.13% and the bonds returned -1.69%.

In addition, in the long term, diversification can also reduce overall portfolio returns. For example, over 20 years ending December 31, 2022, the annualised return of the JSE ALSI index was 13.34%, while the annualised return of the bonds was 9.88%. A portfolio that was diversified across both stocks and bonds would have likely had a return that was closer to the average of the two, resulting in a more consistent return over time, but less than if we only invested in one asset class, i.e the JSE

It's worth noting that it's also important to review and rebalance your portfolio regularly to ensure that it aligns with your goals and risk tolerance 

 

How much should I invest in equities 

The 120 investment rule is a guideline for how much equity exposure you should have in your portfolio. The 120 investment rule aims to invest in high-risk high-reward asset classes such as equities when you're young and decrease exposure over time to your retirement or when you need the money.

The rule is simple, you take 120 minus your age. This amount. Is the exposure to equities that you should have in your portfolio. Quick example. You are 40 years old, so we take 120-40=80. 80% of your portfolio should be invested in equities.

It's worth noting that it's important to review and rebalance your portfolio regularly to ensure that it aligns with the 120 investment rule.

 

Summary: 

Now that you're more comfortable with the terms diversification and diworsification, you can decide how much equity exposure you should have in your portfolio. As the theory goes, the more risk the more your returns should be. Use the 120 investment rule to review how much over or under-exposed you are to equities and amend if necessary. Happy investing!

 

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