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3 Myths of Portfolio Diversification That You Should Know

Diversification can be a polarizing topic among value investors. Even the investing maestros tend to hold widely differing opinions on what constitutes as a good level of diversification, or whether it is needed at all.

At its core, diversification helps the individual investor to avoid losses by spreading their risk around different companies. That said, I have noted some myths about diversification over the years.

Myth No.1 – Buying more companies means more diversification  

Not all companies are created equal. Take global engineering stalwart Singapore Technologies Engineering Ltd (SGX:S63) or ST Engineering for instance. Buying into the conglomerate gives the individual investor global exposure to different industries such as aerospace, electronics, marine and land systems. Arguably, ST Engineering alone is more diversified compared to owning Singapore’s banking trio of Oversea-Chinese Banking Corp. Limited (SGX:O39), DBS Group Holdings Ltd (SGX:D05) and United Overseas Bank Ltd. (SGX:U11). The three banks operate in the same industry, therefore does not provide much in terms of uncorrelated diversification.

Now, this does not mean that ST Engineering is an immediate buy. As always, Foolish investors should focus on the business behind the ticker and do their due diligence on whether the conglomerate can provide adequate return for the future.

Myth No.2 – I want a finger in every pie

Similarly, not every industry or sector may be worthy of your investment dollars. As my fellow Fool Anand Chokkavelu shared before:

“A silly example: Say you’re holding a race among five horses and five human beings. Many investors spend their time trying to rank the five human beings, when they’re better off just betting on the five horses.”

It is not necessary to push your portfolio into disparate sectors just for the sake of diversification. For instance, the investing in airline companies has traditionally not been a profitable venture. The individual investor might be better off avoiding the industry all together instead of putting themselves in a position where they do not have an investing edge.

Myth No. 3 – Diversification is about being in different sectors alone

If the goal is diversification, individual investors could do better than having their portfolios in different sectors alone. Individual investors might want to consider other factors of diversification like different market capitalization sizes, geographical reach, valuation or diversification over time.

For example, if a new investor took 10 years to save up a large pot of money, it may make sense to gradually ease into the market instead to plunking down all their hard earned cash in a very narrow time-frame.

Share markets can turn on a whim, therefore it may help the new investor to manage their emotional state if they bought in thirds.

Foolish take away

On a personal note, my goal is to assemble a group of the greatest companies with the greatest management teams that I can find. Diversification tends to be a by-product of my work, rather than the driving factor. That said, it is useful to set various boundary conditions so that your own portfolio does not overweight towards one sector, market cap or valuation. If you can keep your portfolio in check by reducing errors, that might just help to increase your future returns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.