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Don’t Diversify for the Sake of Diversification

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Investors have heard it all before “in order to reduce risk one must diversify stock holding in different sectors”. Another long held view is “no more than 5% of one’s portfolio should be in any single security”. In most markets this advice makes a lot of sense. In today’s stock market however, diversification for the sake of diversification may work against the investor.

The dynamics of today’s stock market have resulted in an environment where there is macroeconomic risk affecting different sectors of the market. Cratering commodity prices have made previously dependable sectors such as energy and materials very risky. Industrial companies are struggling as weak emerging markets growth combined with the strong dollar eat into company profits. So-called “safe” sectors such as Utilities and Consumer Staples are trading at peak historical valuations as investors have piled into these companies in search of yield.

There are sectors that look cheap on a valuation basis such as consumer discretionary and media companies. These sectors may be value traps however, as companies like Netflix and Amazon have disrupted these industries through technology.

The healthcare sector is full of companies with attractive valuations. In this election year however, it is likely that these stocks may succumb further to political rhetoric. The time to buy these stocks may be better in the second half of the year.

So what is an investor to do? An investor can choose to diversify and buy stocks in all of these industries, or can choose pick individual securities which are especially attractive and keep some cash on hand to buy other stocks once they become more appealing.

Ideal Asset Management prefers the latter strategy in this current market environment. By concentrating a stock portfolio in a few selected securities that offer better expected returns with lower risk than the market as a whole, the investor can generate market beating returns. If an investor employs this strategy, keeping a large portion of cash (between 30-40%) on hand is important. This way the investor can invest in other sectors of the market if they become more attractively priced. Another advantage of a large cash position in the portfolio is that the volatility of the portfolio will be lower, resulting in less stomach churning peaks and valleys.

This strategy should only be used in situations where it is not possible to diversify a portfolio more broadly due to a lack of cheap securities available in the market. And of course, it is critical to choose the right securities to concentrate the portfolio in.

This strategy is not for everyone, but if employed properly, can deliver outstanding returns in overvalued markets.

 

Disclosure:

All of the ideas expressed in this article are the opinions of Ideal Asset Management LLC
Before trading on any of the information in this article, consider consulting your financial advisor to make it suits your financial goals
All investments carry the risk of loss

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