3 Reasons Why Diversification May Not Help Your Finances

Updated: May 14, 2009

Issue

Advice from financial professionals shouldn't be taken lightly. However, the pros' tips and tricks may not be the right strategies for your company. This is especially applicable when it comes to diversification. An old financial apothegm is "Diversify to minimize financial risk." That means dividing your money among many different types of investments, and choosing investments that run counter-cyclically to one another. For example, when stocks go down gold goes up, so you should keep some of your money in gold to counter dips in the stock market. Diversify to minimize the risk that any one investment category will tank.

But are you investing to minimize the risk of losing money, or to maximize the "risk" of making money? The fact is, diversifying reduces your risk of significant financial loss but also reduces your hope of significant financial gain by exactly as much. It's like a game of tug-of-war; some of your money is pulling against the rest. If you perfectly diversify to "minimize financial risk," you neither lose nor gain any money. So why diversify to minimize financial risk?

Considerations

1. Avoiding worry is one reason for minimizing financial risk. But as Max Gunther said in The Zurich Axioms,"Worry is not a sign of sickness but a sign of health. If you are not worried, you are not risking enough."

If the amount you have in a particular investment isn't worth worrying about losing, it isn't big enough to earn you any worthwhile return, either.

2. Liquidity has its financial risks and rewards. Every business occasionally needs a shot of cash in a hurry. Some of your money should be in a checking account to cover today's emergency. Money for a less pressing emergency can be kept in a savings account, mutual fund or other slightly less liquid asset. Minimize the financial risk of running short of cash.

When you have enough liquidity - whatever amount that is - put the rest in higher-yielding, longer-term investments such as CDs. Invest in stocks for the very long term, ignoring cyclical ups and downs with the faith that stock prices rise, on average, over the long haul. So goes the diversification theory.

But your faith that longer term investments will produce higher yields may be misplaced. Opportunities to "make a killing" come suddenly, peak and pass swiftly. If your money is tied up in long-term investments, you will miss these sudden spikes in opportunity.

3. Make money for your financial adviser. This is the real reason to diversify. You don't have the time or expertise to find viable investments in a dozen different categories, monitor their performance, then buy or sell them when appropriate. So you pay someone to juggle all those balls for you, while you attend to the business you know.

The Bottom Line

Diversifying your financial assets is smart, but only in some situations. Reasons abound for you to rethink this traditional investment strategy. Before withdrawing your funds and reinvesting them in high-risk projects, however, you'll need to be clear to your business's board and financial team about what you want to do. Working together, you can develop the best investment strategy for your organization.

For more information on business financial issues, check out the Financial Services Resource Center, where you'll find comprehensive research, topical research briefs and advice from Focus Experts.

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