The forgotten risk of not diversifying

Investors with only one or a few stocks in their portfolio are taking too much risk. This article looks at why and how diversification can maximize your potential for long-term gains by reducing risk.

The big risk: owning just a few stocks

New investors will often start their investment lives by testing the waters with the purchase of stock or two in companies they have some kind of connection to or feelings about. But this is rarely a setup for long-term success, and a diversified core portfolio is an important first principle of building more stable, long-term success.

When you only invest in a few companies, your entire portfolio depends on the performance of those companies. And while you can always see what happened in the rear-view mirror, no one can know how the future will shape up for a company. Imagine having built a portfolio consisting of Kodak, Blockbuster and Nokia stocks in the late 90’s after those three names stood atop years of spectacular gains. By the 2010’s all three companies had collapsed, leaving investors with virtually nothing. Worse still, investors having chosen individual shares often feel “married” to the position, hoping the prices will return to their highs and incapable of making the decision to exit the position, fearing the emotion that they will take a loss just at the wrong time, only to see the share prices soar again. That is the definition of “decision regret bias”

Diversification to the rescue

Diversification is the first tool investors should consider to avoid being caught with a risky portfolio where one event may jeopardize your savings and caught in the cross-fire of emotions that make decisions difficult. The idea with diversification is that you spread your investments across sectors, countries and industries to lower your portfolio risk, while still maintaining exposure to the upward drift in the market over time. With a diversified portfolio a financial event may be negative for some of your investments but positive for others.

Best of all, a broad exposure to the market triggers far fewer of the behavioural risks that choosing individual shares does. It’s quite a confidence boost to know that, with a more diverse approach the stock market has historically always come back over a long enough time horizon, even if individual companies may not.