Diversification is a cornerstone of investment strategy, but you can overdo it. When you’re over-diversifying, you are actually working against yourself. It waters down your returns and portfolio’s performance. But, how can you tell if you’re over-diversifying?
What is Over-Diversifying?
In finance, diversification is an investment strategy to reduce market exposure and mitigate risk. By allocating your personal capital into various assets and across industries, you protect your portfolio against large market fluctuations. You want assets with varying correlations as well in order to safeguard your investments.
However, having too much diversification inhibits your portfolio’s performance. When you have too many holdings or investments of the same type, it tips the risk/return trade-off against you. Using a term coined by Peter Lynch, ‘diworstification‘ happens when you are investing in too many assets that have similar correlations. When you do this, you are adding unnecessary risk without the reward of higher returns.
Dangers of Over-Diversification
Think of over-diversifying as having too many eggs in too many baskets. Even if some holdings perform well, it decreases your returns when you focus on quantity over quality. The minimal gains are offset by under-performing stocks in your portfolio and usually mimic the stock market’s performance. Over-diversifying dilutes your returns without a meaningful reduction in overall risk.
Furthermore, it costs you more in additional fees and undercuts your investing strategy. Not only do you pay more in maintenance fees, but it also requires more time and due diligence on your part.
Another danger of over-diversification is that holding too many assets can be confusing and difficult to track. There is also greater risk that you will own assets you don’t understand or that don’t align with your investment strategy. As with all things in life, too much of a good thing can quickly become a bad thing.
Signs You Are Over-Diversifying
Over-diversification is not something that happens overnight. It sneaks up on you over time. In most instances, it is a result of collecting assets which you never sell or trade. If this sounds like you, here are four signs that you might be over-diversifying.
1. Having Too Many Similar Funds
One of the first signs is when you have too many similar investments. Even though you may have purchased them through different brokerages, you may have overlapping shares if you bought stock in similar funds. In fact, there is no more diversification in your portfolio than if you held a single mutual fund of ETF.
To avoid over-diversification, you should choose different types of funds that have a wider range of offerings. If you own too many stocks in the same sector or have similar correlations, discuss ways to focus your strategy with your financial advisor.
2. Purchasing Too Many Individual Stocks
Another sign is if you hold too many individual stocks. Not only will this become a headache when you file taxes, but it also demands a ton of your time with due diligence. The worst part is that you weaken your portfolio’s performance when you hold multiple positions. Your portfolio will likely mimic the stock index instead of producing significant gains.
A more targeted approach to diversification will produce better profits. Although financial advisers disagree on the exact number, the general rule of thumb is 20 to 30 companies. This will give you optimal diversification without over-diversifying.
3. Overusing Multimanager Products
Although multimanager products can give you instant diversification, you might be better off with a more direct investment strategy. Funds of funds and feeder funds add extra levels of complexity and due diligence. In reality, do you really need to pay your financial advisor to monitor an investment manager who is monitoring other investment managers?
4. Maintaining Assets You Don’t Understand
If you hold assets that you don’t understand, you could be taking on more risk than you realize. Private, non-publicly traded investments may provide more diversification, but their risks are often understated. The value of such assets is based on appraisals rather than market transactions. Therefore, non-publicly traded holdings could be riskier than they appear. Instead of unknowingly exposing yourself, choose assets you understand and that advance your investment strategy.
Balancing Your Portfolio
When it comes to building your portfolio, there are endless sources of advice and investment strategies out there. However, any reputable financial advisor will tell you that diversification is a good way to limit market exposure and mitigate risks. But, you must also remember that diversification does not guarantee against losses.
In order to achieve a balanced portfolio, you have to keep it manageable. Having too many assets weakens your returns while having too few in your portfolio is a gamble. You also want to maintain assets of varying correlations to achieve optimum diversification. This can help to nearly eliminate risk, but limit your holdings enough to concentrate on the best financial opportunities.
A well balanced portfolio will deliver consistent returns. If you are concerned that you may be over-diversifying, you can use the Morningstar free tool to evaluate your portfolio and point to areas you can improve. While diversification is a sound investment strategy, you also want to be cautious not to take it too far. The point is to reduce your portfolio’s volatility, not the potential returns.