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Is Diversification a Good or Bad Investment Strategy?

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Why you may want to reconsider what true diversification is

When it comes to investing, the so-called experts preach to the masses with this advice: “Invest in a diversified portfolio of stocks, bonds, and mutual funds.”

Why would they give this advice? It comes from good intention, no doubt. The thinking behind the conventional advice on diversification is that if one part of your portfolio is hit by bad market conditions, then you’ll be able to hedge with other parts of your portfolio.

Seems like good advice then, doesn't it? What could possibly be wrong with spreading your risk among a number of different investment vehicles? In that context, diversification is the easiest way to help people who have no financial education manage their risk. Diversification is really good advice for financial idiots.

As we’ll see later in this article, it actually exposes them to even greater risk. And if you want to be really rich, you need to understand why diversification (at least how it’s popularly talked about in the financial world) is a bad idea.

Why “diversification” is bad advice

First things first, what most people consider as diversification isn't really diversification.

Rather, it is spreading your money across one asset class. Stocks, bonds, and mutual funds are all part of the same asset class-paper assets. A 401K that invests in primarily index funds is an investment vehicle that simply spreads money across one type of investment: stocks. That is not true diversification.

That is actually specialization, and if you’re doing it blind, you’re exposed to great risk. In the event of a total collapse of the paper asset sector (i.e., a deep recession or depression), all your assets will sink. And if the timing is bad, it can be devastating—just ask the retirees who went through the Great Recession.

Why understanding true diversification is important

There are actually four asset classes: paper, real estate, commodities, and business. A truly diverse portfolio would have stakes in all or most of these.

If you’re planning on using diversification as a hedge strategy, at least do it right and make sure you’re diversified over all four asset classes, not just in paper assets. That at least will protect you much better from a total loss of your wealth should one asset class crash.

But at the end of the day, diversification is a zero-sum game. Gains in one class offset losses in another. Sure, it can be safe, but rarely does someone become rich by diversifying. As Warren Buffet says, “Wide diversification is only required when investors do not understand what they are doing.“

Diversification, systemic risk, and non-systemic risk

The reason diversification is a high-risk way to invest becomes clear when you consider systemic and non-systemic risk.

A number of years ago, British Petroleum suffered a major oil spill. During that time the company’s stock dropped by over 50%. This did not impact the market, however, and things carried on as if nothing happened in other stocks, the real estate market, etc.

That is an example of non-systemic risk. If you had all your money in BP stock, you would have been hurt, losing half your wealth. But it would be isolated to that one company. The rest of the market investors would be fine.

Amateur investors try to manage the type of risk that would come from focusing on one stock, in this case BP, by diversification across the stock market. The problem is that they then get exposed to systemic risk, which is much riskier.

An example of systemic risk is the subprime mortgage meltdown. Brokers handed out mortgages like candy, approving zero down, stated income, no documentation loans. When millions of people who lied to get a house they couldn’t afford stopped paying those loans, the entire system was impacted. The S&P 500 index dropped by over 50%.

When it comes to systemic risk, diversification won’t help you. And systemic risk is always a matter of not if, but when. If you’re lucky, it hits when you still have time to recover. If not, well then you’re screwed. It’s a big gamble when there are other strategies you can put into place that will not only protect you better but also make you far richer...if you have the financial education needed to execute on them.

Diversification vs. unfair advantage

My friend and Rich Dad Advisor, Andy Tanner, is a master at paper assets. He’s also incredibly tall. At 6’8”, Andy naturally became an accomplished basketball player in his younger years.

Andy shared with me a story about his younger brother, who is eight inches shorter than him. They often played basketball together in their driveway. Andy’s younger brother never once beat him. “It’s not fair!” Andy’s brother would howl.

“You’re right,” Andy’s parents would say. “Life isn’t fair.”

When it came to basketball, Andy had an unfair advantage over his brother. His natural height helped him dominate the game. He wasn’t cheating. He still followed the rules, but he used his unfair advantage to win every time.

The most successful investors don't diversify. Rather, have an unfair advantage over amateur investors. They focus, specialize, and insure their investments against risk through contracts.

They get to know the investment category they invest in and how the business works better than anyone else. For example, when investing in real estate, some investors focus on raw land while others focus on apartment buildings. While both are investing in real estate, they are doing so in different ways.

They then use contracts, like a rental contract, to guarantee income for twelve months and insurance to protect them from loss, to lock in their unfair advantage and make money even if the markets go up or down.

The secret that the rich know is that you can insure any investment in any asset class, even in stocks. It takes financial intelligence to know how to do this, and if you want to learn more, I encourage you to explore our learning options in Rich Dad Workshops.

When diversification is good advice

So, again, given what we’ve discussed here, why do financial advisors recommend diversification when the world's greatest investors choose not to diversify their portfolio?

In short, they do it to protect the ignorant...or, again, what I call financial idiots. There are pro and amateur investors. Warren Buffett is a pro investor. Most people are amateurs. A pro investor, for instance, would know that an oil spill for BP would mean it would be time to hedge against loss. An amateur investor would make a move after he had lost too much money. Pro investors should focus. Amateur investors should diversify.

The real question is: Do you want to become a professional investor or remain an amateur? If you choose to remain an amateur then, by all means, diversify. Diversification keeps you from “putting all your eggs into one basket,“ so if one stock collapses, as BP did, only a portion of your portfolio will be affected.

If, however, you decide to become a pro investor, the price of entry is focused dedication, time, and study. Warren Buffett dedicated his life to becoming the best investor he could be. That is why he focuses and does not diversify. He does not need to protect himself from ignorance simply because he has invested time and money to understand what he is doing.

Intense focus, intense rewards

In Hawaii, there is a great organization known as Winners Camp. It teaches teenagers the attitudes and skills required for success in life. Winners Camp uses the word “focus“ as an acronym, standing for “Follow One Course Until Successful.“ I believe all children should be taught to focus, as should any investor who wants to be a rich investor.

If you look at anyone who has achieved great success and wealth, they have all focused intensely in order to win.

Rather than practice diversification, I encourage you to practice focus. In the process you will take control of your financial future in ways that amateurs simply cannot.

Original publish date: July 26, 2016

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