Diversification is one of the few free lunches available in the investment world. Spreading ones money over many investments allows investors to achieve similar returns as undiversified investors over the long run, but with much less risk.
Undiversified investors often concentrate their wealth, amassing outsized positions in a small group of stocks or in just one type of asset. They may feel like they have the upper hand over their ‘boring’ diversified counterparts until something goes wrong. Then, well, they might not have anything to do but hope their luck turns.
Here’s a real world example of what can go wrong with an individual stock:
Teva Pharmaceutical is the worlds largest generic drug manufacturer. One out of every six prescriptions in the U.S. is filled with Teva products and it makes a staggering 120 billion pills a year. Looking at the stock in July 2017, an investor would have seen a stock that had struggled a bit so far that year, but still maintained great profit margins, a robust pipeline of new drugs in development and a sizable dividend. But then in early August 2017, Teva announced it was lowering its earnings forecast, cutting its dividend drastically, and might have trouble with its debt. The stock dropped 24% that day and fell another 16% in the week that followed, bringing its performance since the start of the year to negative 52%.
The point investors should understand is that bad things can happen to good companies to any company actually. When investors amass large percentages of their wealth in a specific stock, they are setting up the potential for a very disappointing future.
Yes, by concentrating ones money, one may end up hitting a home run and ending up with a huge gain. But most people don’t need home runs to meet their goals in life.
The more consistent returns of a diversified portfolio are a great platform for planning ones future. With diversification, when bad news hits a specific company, investors can keep on enjoying life knowing any one security will not make or break achieving their goals. But a non-diversified investor, suddenly hit by a large loss, may have to modify plans or scrap goals all together.
While a diversified portfolios performance can trail the returns of the latest and greatest asset in any one year, the advantages become much more evident when unexpected bad things happen. Diversification can be a great tool during times of adversity and is a cornerstone of sound investing.
Jonathan Bernstein is a Senior Research Analyst within Hefren-Tillotson’s investment advisory group. Jonathan is a graduate of Yale College, a Chartered Financial Analyst charter holder (CFA) and a CERTIFIED FINANCIAL PLANNER certificant.
Hefren-Tillotson Inc., is a leading diversified financial services firm providing investment and retirement plan management and comprehensive, financial planning through MASTERPLAN for individuals and businesses. The firms wealth management services are administered by Certified Financial Planner (CFP) professionals, Chartered Financial Analyst (CFA) Charter holders, attorneys, Chartered Life Underwriters, and CPA/PFSs. Hefren-Tillotson offers corporate services including 401(k) retirement planning, executive financial counseling, fiduciary reviews and workplace financial planning seminars. Founded in 1948, the firm is headquartered in Pittsburgh and has offices located in Pittsburgh, Butler, Greensburg, North Hills, and South Hills.
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