To Diversify or Not that is the Question?

Almost every Financial Advisor will tell you to be sure and develop a well diversified portfolio. However, is that always the best advice?

To assess this question let’s see if we can understand what diversification is doing using some common sense. With that in mind, let’s compare diversification with a college class with 100 students versus a college class with only 5 students.

Using this example, we can see that by investing in the 100 students and accepting the average of the grades that these 100 students get, we are protecting ourselves against unforeseen students with negative results BUT we are also accepting that we are averaging the amazing students with the overall group and thus bringing down our exception results to a lower average.

So, the question is why don’t we just search and find the top 5 students in the class and invest entirely in those students.

The answer being we can but only if we’re willing to accept the risk that we’ve chosen the worst students in the class instead of the top students in the class. And although we can review each of the student’s performance regularly, there’s never any way to say for sure that we don’t get it wrong.

So, if you’re will to accept the risk that you may not get the best students (or investments), then you are able to reduce your diversification and potentially get much better returns.

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