Ask any fund manager about the most difficult part of their job, and chances are, they will say portfolio diversification. The success of any investment depends on the way assets are diversified. Fund managers are the best persons who can suggest which fund, stock, or bond can yield how much dividend and which investment is worth keeping.
Diversifying assets requires proper judgment and rational thinking. Many investment failures can be attributed to lack of proper diversification.
Wrong diversification indicates improper judgment of market performance. There are many reasons why diversification can be a tricky issue.
Priorities are not defined
When investing, you have certain goals or priorities in mind. The type of investor you are—aggressive or conservative—will reflect in your diversification. When you diversify assets in stocks, bonds, or funds, the weightage you assign to each asset is important. For instance, if you allocate 60% to stocks, 20% to bonds, and 20% to funds, and if stocks fail, your portfolio will fail. Once you are sure where you want to head, allocation becomes easier.
Emotional attachment
Emotions and investments do not mix together. When you see the stock market soaring, you want to include certain stocks in your portfolio and that is when the entire portfolio becomes imbalanced. Of course, often, one needs to diversify assets across different sectors, but heading in one direction based on the performance of one asset is not advisable.
Preference for one asset class to other
What is your preference? If you want a fixed income every month, investing in funds and fixed-income securities is recommended. Choose an asset class based on your goals. For some, passive investments such as REITs (Real Estate Investment Trust) work, whereas for others, yearly or quarterly dividends are important. But choosing one asset class and ignoring the other will create disbalance in your portfolio. Chances are you might miss out on profitable opportunities because of wrong diversification.
Going overboard
Diversification is good but going overboard means compromising on returns. If you have a certain sum to invest and you invest in one asset class with 10 to 15 holdings, you are leaving nothing for other asset classes. How can you minimize your risk if you fail to recognize the potential of other assets that can maximize your returns and lower your transaction cost?
Multiple accounts
Having multiple accounts helps spread out risk, but the resulting confusion is not worth it. This is mostly seen with couples, with each spouse having their own 401(k) and IRAs and some other investment accounts. When you take a stock of them, you realize diversification in this way is not right.
Not all diversification can be perfect. Even if you diversify to the best of market abilities, no one can beat how the market will react to any allocation. Although experts suggest that balancing is the key, balancing is subject to market predictions as well.
