The limits of diversification

Diversification is important for equity and equity fund investments, but investors should understand its purpose and limits

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Everyone who invests knows that diversification is a highly desirable quality for one's equity or equity fund investments. However, after that, most of us tend to be a little vague about what exact benefits diversification brings. The loose understanding is that diversification prevents losses and is achieved by investing in a large number of stocks or mutual funds. This idea has a rough resemblance to the truth, but is not correct enough to be actually useful.

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I've received emails from investors listing out portfolios that consisted of 40 or 50 funds of exactly the same type. The owners were really happy with the diversification till there was a general fall in the markets and then they were stunned that they lost money. In reality, diversification, while necessary, will protect you against a specific, narrow kind of problem. It should be pretty obvious that when the entire market falls then all equity funds fall and the value of your portfolio is going down whether you have invested in one or two companies/funds or ten or fifty.

What diversification of this sort will do is save you from problems in specific investments. If one company or one fund or perhaps one industry does worse than the market, then having a number of other investments will save you from suffering too deep a decline in your portfolio value. As for what happens when there is a general decline in stocks, the cure for that is time and well-chosen investments. Eventually, things turn around, as they did even in deep crashes like 2008-09. Understanding what diversification does for one's equity investments and not expecting too much from them is an important part of one's education as an equity investor.

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