It is common knowledge in investing that maximum diversification is the best defense an investor can have. The thinking goes that by having a bit of money in every possible asset class, then the portfolio will be more resistant to downturns in any one asset. There are several issues with this theory however. Here we will look at the issue of small allocations.
If an investor is in the accumulator phase of life, it may be detrimental to be maximally diversified. In this example portfolio, an investor has done a “good job” diversifying his portfolio. Here is his allocation:
- US stocks – 30%
- International stocks – 20%
- Bond funds – 30%
- Real estate ETFs – 10%
- Precious metals ETFs – 5%
- Cash – 5%
This investor is well diversified by standard reasoning. Fifty percent stocks, 30% bonds, metals and real estate. A nice portfolio indeed.
This investor has diversified his stock holdings with a 5% allocation to exchange traded funds of gold and silver. A worthy move for diversification’s sake. What problem do I see with it? If this investor is trying to grow their portfolio, 5% will have a minimal affect on their account size.
Let’s take a look at why. Say gold has a good year and goes up by 10%. Great! Our investor will look at his account statements expecting to see a nice increase in his portfolio, however what will he see? His 5% allocation, that is up 10%, will only increase his overall portfolio’s value by… wait for it…. 1/2%! Wow. Great. Thank you diversification.
He was invested in an asset that went up ten percent and his portfolio is only up 1/2%? That doesn’t sound right, but an increase of 10% on an allocation of 5% does indeed bring an overall increase of 1/2%. Let’s check the math.
- Starting portfolio value: $100,000
- Gold ETF allocation starting: $5,000
- Gold ETF allocation after 10% increase: $5,500
- Portfolio value after gold increase: $100,500
- Percentage increase of entire portfolio: (100,500 – 100,000) / 100,000 = 0.005 or 0.5%
The benefits are even smaller if the metals don’t have a good year. If gold returns 4%, then the investor will only see 0.2% rise in the overall portfolio. If this investor is trying to accumulate wealth for retirement, then diversifying isn’t helping him in a situation like this.
Maximum diversification does not always bring significant benefits for all investors. The percentage allocated to each asset has to be large enough that it actually moves the needle. The examples above are too small to move the needle in the overall portfolio. For investors looking for growth in their portfolio, 5% allocations are inconsequential.