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Concept One: Leverage Diversification to Reduce Risk


Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. That’s a very simplistic view of diversification, however. It can also get you caught in a dangerous trap—one that you may already have fallen into.

For example, many investors have a large part of their investment capital in their employers’ stocks. Even though they understand that they are probably taking too much risk, they don’t do anything about it. They justify holding the position because of the large capital gains tax they would have to pay if they sold, or they imagine that the stocks are just about ready to take off. Often, investors are so close to particular stocks that they develop a false sense of comfort.

Other investors believe that they have effectively diversified because they hold a number of different stocks. They don’t realize that they are in for an emotional roller-coaster ride if these investments share similar risk factors by belonging to the same industry group or asset class. “Diversification” among many high-tech companies is not diversification at all.

To help you understand the emotions of investing and why most investors systematically make the wrong decisions, let’s look for a moment at what happens when you get a hot tip on a stock. (See Exhibit 2.)

If you’re like most investors, you don’t buy the stock right away. You’ve probably had the experience of losing money on an investment—and did not enjoy the experience—so you’re not going to race out and buy that stock right away based on a hot tip from a friend or business associate. You’re going to follow it awhile to see how it does. Let’s assume, for this example, that it starts trending upward. 

You follow it for a while as it rises. What’s your emotion? Confidence. You hope that this might be the one investment that helps you make a lot of money. Let’s say it continues its upward trend. You start feeling a new emotion as you begin to consider that this just might be the one. What is the new emotion? It’s greed. You decide to buy the stock that day.

You know what happens next. Of course, soon after you buy it, the stock starts to go down, and you feel a new combination of emotions—fear and regret. You’re afraid you made a terrible mistake. You promise yourself that if the stock just goes back up to where you bought it, you will never do it again. You don’t want to have to tell your spouse or partner about it. You don’t care about making money anymore. 

Now let’s say the stock continues to go down. You find yourself with a new emotion. What is it? It’s panic. You sell the stock. And what happens next? New information comes out and the stock races to an all-time high.

We’re all poorly wired for investing. Emotions are powerful forces that cause you to do exactly the opposite of what you should do. That is, your emotions lead you to buy high and sell low. If you do that over a long period of time, you’ll cause serious damage not just to your portfolio, but more important, also to your financial dreams.

But truly diversified investors—those who invest across a number of different asset classes—can lower their risk, without necessarily sacrificing return. Because they recognize that it’s impossible to know with certainty which asset classes will perform best in coming years, diversified investors take a balanced approach and stick with it despite volatility in the markets.

Questions about our investment philosophy? Please call our office or contact us here to schedule a time to discuss further.

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[1] Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance, May 1968.
Mark M. Carhart, Jennifer N. Carpenter, Anthony W. Lynch and David K. Musto, “Mutual Fund Survivorship,” unpublished manuscript, September 12, 2000.
Christopher R. Blake, Edwin J. Elton and Martin J. Gruber, “The Performance of Bond Mutual Funds,” The Journal of Business, 1993: 66, 371–403.