3 mistakes you are making in diversifying your portfolio

The holy grail of investing is to diversify a portfolio. The purpose of diversification is to dilute the risks by spreading investment into different investment vehicles. However, most investors do not understand it and make mistakes in their diversification, which negatively affect their returns. This is the result of a sub-par diversified portfolio.

Most investors either misunderstand or misinterpret the information available on their investments. It leads to either over or under-diversification of their portfolio, which ultimately hurts the ROI. To diversify your investment optimally, you need to research the assets you have chosen to invest in. In reality, this suggestion is vastly misapplied. Here, we will explore 3 mistakes you must avoid from hurting your returns and diversifying your portfolio optimally:

1. Naive Diversification strategy

A study conducted by Econstor found that a majority of the investors diversified their portfolio based on an accepted yet elementary approach that is only sufficient to reach a financial goal but not to achieve investment growth. For example, investing in stocks, funds, and real estate is a common diversification strategy used by most investors that creates a below-average portfolio with poor returns, not losses necessarily. In this situation, the investor only looks at allocating his money into various assets because the golden rule says so. This is widely known as a naive diversification strategy or diversification heuristic.

The investor has not studied those individual assets well enough to find a positive or negative correlation between them. A positive correlation means the assets fluctuate together, and both will be affected simultaneously by a market boom or crash. A negative correlation usually removes the risks of combined assets. Lack of this understanding could lead to both over and under-diversification because the conclusion is based on a simple rule and not research relevant to the investment blueprint. Your investment blueprint should outline your investments' goal and establish each step to facilitate you to achieve it. It should avoid including any measures and assets that would contradict the financial aim - in this case, putting two assets together that positively correlate and has the risk to suffer losses at the same time. Here, you need to analyse whether the assets are dependent on each other to avoid more significant losses when the market crashes.

2. False diversification decisions

People look for patterns in places where there are none, and if there are any, it is not supposed to be admitted as of actual value. The same goes for investments. For example, investment brokers repeatedly disclaim that "past performance does not indicate future returns," yet investors still cannot help but use the information as their basis for investment. They misinterpret any input and look for patterns only to end up with useless information. This is because investors prefer some amount of data, no matter how small or irrelevant they are. The same study by Econstor found that investors use any resource available as justification for their poorly diversified portfolio even though the information is incomplete or invariable. It leads to false diversification decisions and an inferior portfolio. Here, you need to take this information with a grain of salt before making a decision. If you are unsure about that specific asset class, then invest in the ones you have more concrete information on.

3. Not adjusting risk-exposure

Investors often forget that every single asset has its risk exposure which needs to be adjusted. Instead of taking a few asset class with the proper amount, investors tend to gravitate to taking a slice of each. Carnegie Mellon University has found a diversification bias where people tend to choose more varieties, thinking it would maximise output. In terms of diversification in an investment portfolio, an investor may choose several asset classes in equal amount without understanding their volatility. For example, if someone invests in a real estate backed platform with a high default rate and a business based platform with a mild default rate - the results do not even come close to covering the losses. Hence, the risks taken are not worth investing in the first place. This results in an investor making a naive diversification of his portfolio. An investment with high volatility will not be counterbalanced with a low volatility asset. Instead, you need to choose another highly volatile asset with a low correlation to other assets.

The mistakes discussed above are not an exhaustive list, just those not frequently explored in diversification. Many financial experts have studied investors' tendencies to better understand their mindset behind their investment choices to improve decision making. They have found that investors feel a lot better if there are resources for them to rely on because it gives them the security of certainty. However, what investors need to do instead, is understand the past information and try to connect it with the current market situation. If the results make sense, then investors should accept the information as the basis for their decision.

Last update: 26/03/2021