Best Practices When Diversifying Your Portfolio

Founder, CEO of Blue Lake Capital LLC. Helps passive investors grow wealth through real estate. Podcast Host: REady2Scale.

Diversification is a word that tends to stir up a lot of strong opinions. Some people believe it is the be-all-end-all strategy for investing success, and others believe it is a fool’s errand and anyone who tries is destined to fail.

Even some of the most well-known business experts and investors, such as Mark Cuban and Warren Buffett, have seemingly differing opinions on diversification. Mark Cuban has said diversification is “for idiots.” Warren Buffett, on the other hand, advised people who are not professional investors to “participate in total diversification.”

From my perspective as the founder of a commercial real estate investment firm, I believe diversification, when done correctly, may help generate stable returns while mitigating risks. However, when it is done incorrectly, it can result in people buying far too many assets and failing to keep track of them properly.

The Risks Of Overdiversifying

Some people get “shiny object syndrome” and buy dozens or even hundreds of assets they don’t know much about and don’t have time to watch carefully. This is called “overdiversifying.”

People who overdiversify run the risk of buying assets that are poor quality, too volatile or don’t make sense for their current financial situation. Managing assets takes time and energy, and if you have too many assets in your portfolio, then some of your assets might be declining in value, and you might not even know it before you lose significant sums of money.

The Risks Of Underdiversifying

On the opposite side of the spectrum is underdiversifying. Underdiversifying is when people place far too large of a percentage of their portfolio into just one, two or maybe three assets.

No matter how high-quality an asset is or how great its past performance has been, if you put too many eggs into one basket, you could experience a high degree of pain if that asset has trouble. Sometimes, people who underdiversify also fail to recognize great opportunities because they are too biased toward the few large investments they are already holding.

Finding The Right Balance

The key to diversifying successfully without overdoing it or underdoing it is to find the right balance. This means holding enough high-quality assets in your portfolio to protect against devastation if any of them plummet, but also not having so many that you cannot properly manage them and keep up with them.

For example, for some people, the first asset they might add to their portfolio is a high-quality index fund. This is because index funds already have diversification built into them. Many indexes represent a number of high-quality, top-performing companies bundled into one asset.

Or, perhaps you’re looking for one or two good stocks in a few different industries. Ideally, there would be an industry in which you have some knowledge or experience. This can help you to pick winners. A good place to start is to look for some of the most successful companies in the industry of your choosing—companies that have sustained consistent growth over many years. You can analyze charts of stock performance to see if the stock you are looking at meets this criterion.

Some also invest in one or two different asset classes. This could mean buying bonds, buying precious metals or buying real estate, for example. Being in the real estate investment space, I’ve seen that many people buy either single-family homes or multifamily properties as real estate investments, or they explore a real estate investment trust. A REIT is a company that pools the assets of investors and invests them in income-producing real estate properties. REITs are required to pay at least 90% of taxable income to shareholders in the form of dividends each year.

When it comes to diversification, I believe too much or too little can both be risky. The key is to find the sweet spot in the middle. Do not make the mistake of jumping on every latest craze. Instead, pick assets designed to perform well over time. You never want to have so many assets in your portfolio that you cannot supervise them properly.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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