A diversified portfolio refers to a portfolio containing different investment assets in balance. The idea is that an investor would include both stocks and bonds, for example. On the other hand, a concentrated portfolio refers to a portfolio that contains investments with very similar risk and return goals. In other words, a concentrated portfolio would be made up mostly of low-risk bonds, while the diversified one might have some stocks in it as well.
How a Portfolio is Diversified
You can diversify your portfolio using several different methods. The first way is to diversify among several companies, holding a portion of all stocks in your portfolio. Another method is to use mutual funds or exchange-traded funds. You can also diversify by investment style by providing a broad, diversified range of asset classes and investing in several different types of assets. Diversifying your portfolio will protect you against rare events like total market collapse. Here are the benefits and disadvantages of concentrated and diversified portfolios.
Benefits of a Diversified Portfolio
The biggest benefit of a diversified portfolio is safety. By holding assets from different companies, industries, and countries, you are protected against any single company or industry for doing poorly. In other words, you have no exposure to a loss resulting from only one company or industry. You can also realize higher returns by investing in several companies, each with its own unique risk and return characteristics. The theory is that if one investment in your portfolio goes bad, the others will offset any losses.
Drawbacks of Diversified Portfolio
However, diversification can be overdone. If you invest in too many companies or industries, you risk minimizing the impact of good performance by averaging everything together and getting average results. You may also diversify too broadly so that your portfolio doesn’t have enough assets to be useful. In other words, it’s hard to tell whether you have diversified too much or not enough because it’s impossible to know what your benchmark should be. At the same time, you might get poor returns if the underlying investments are underperforming.
Benefits of Concentrated Portfolio
A concentrated portfolio has its benefits, especially when it comes to performance. When you put all your money into one investment or a few investments, you take on more risk. So, if that investment does well, you have a high return on investment. If that investment does poorly, you make losses. You can then combine your returns between your investments and achieve higher returns while still being protected against rare events.
So, which one is better? There are benefits to both. Diversifying can help you take advantage of market trends and increase your return, but investing too much in too many different places could hurt you. It all depends on the balance between safety and higher returns.