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Investor’s Best Friend
Portfolio diversification is built on the philosophy of ‘don’t put all your eggs in one basket.’ By spreading investments around, your exposure to any one asset becomes limited, reducing the risk brought by a market crash or a stock that performs poorly over a period of time.
Diversification acts as the buffer that takes the hit when things go wrong. By having multiple investments in hand, you mitigate the negative performance of some by the positive performance of others.
Of course, this only holds true when the securities in the portfolio are not perfectly correlated (i.e., they behave differently in different market conditions).
It seems like you can never diversify too much. After all, minimizing risk as much as possible should be a good idea, right?
Wrong. We’ve all heard the phrase “too much of a good thing.” Well, it fully applies to portfolio diversification.
The Curse of Over Diversification
Naturally, over-diversification is a result of the desire to minimize risk.
Brokerages often push the over-diversified, actively-managed equity strategies for one core reason: equity products and services carry the highest profit margins for them. Now, this has gotten better with the idea of robo-advisors, but the problem still exists.
Over-diversification can hurt your investments due to several reasons. Let’s look at some of them:
It’s good to have a decent number of assets, but you have to keep in mind that there are only a handful of high-performing companies within any investment sector.
If you’re investing in a lot of different stocks in each sector, you’re most likely loading up on stocks that are far from being top performers.
The low-performing stocks will drag down your returns, and your return on investment would probably be better if you had limited your exposure to a few different high-performing companies instead of a whole bunch of mediocre ones.
Law of Diminishing Returns
To build off the point made above, the law of diminishing returns also applies to portfolio diversification. Diversifying across several sectors or asset classes is a good thing, but too much within the same sector or asset class will likely have the opposite effect.
It’s even possible to diversify your portfolio “ad infinitum,” where you’re just holding a collection of securities so elaborate that poor performance becomes inevitable.
Getting into a large number of companies within a sector does not mean you’re diversifying. You’re better off investing in a relatively small number of successful companies instead. In the end, the best returns come from the strongest companies.
False Sense of Security
We’ve heard about the benefits of portfolio diversification so many times that somewhere at the back of our minds, we probably think it can save us from any losses. Being too diversified can lull you into a false sense of security.
You may start thinking that because you have so many securities in your portfolio, you will be less susceptible to losses during a general market decline. As I’ve already noted, this couldn’t be further from the truth.
Assuming that having a highly-diversified portfolio could help your returns, it doesn’t change the fact that managing all your investments will become a nightmare. You’ll have more stocks and funds than you can manage, more buy-and-sell decisions to make, more rebalancing, and the high costs that accompany each of these activities.
This problem is reduced when you choose a robo-advisor, as they pick your funds for you. But if you notice, brokerages like Wealthfront will limit how many funds are actually in your portfolio–so they have the same idea.
Warning Signs That Your Portfolio is Over Diversified
So, now you know why you shouldn’t over-diversify. Let’s say you’ve already invested in some securities.
After all, low levels of diversification also pose risks. How do you know if you’re over-diversifying?
Too Many Mutual Funds in a Single Investment Category
Sometimes, people try to diversify their portfolio by investing in multiple mutual funds within investment categories. Though this may look like a good way to go about it, it fails at a very rudimentary level.
Investment managers all have access to the same information, and competent ones will often reach the same conclusions about which stocks and companies are a good investment.
What’s the result? Different funds in the same sector often end up having the same stocks.
For example, let’s say you are investing in three different funds in the technology sector. If the manager for each of these funds is well-versed in their field, they’d likely have their eyes on the top-performing technology companies.
If these three funds have 30 shares of stock from Apple and Samsung, then you will end up with 90 shares of Apple and 90 of Samsung’s.
By investing in multiple funds dealing in the same category, you end up achieving duplicate diversification–which isn’t really diversification at all.
Over-using Multi-manager Investments
“Multi-manager” financial investment offerings, like funds of funds, are typically a quick way that traders take to achieve immediate diversification.
If you look into these products, you really should analyze the diversification gain (which is certainly in a questionable position, granted that funds of funds might also carry various funds which contain the same stocks) against the lack of modification, elevated costs, and even diluted diligence when it comes to management.
So what I’m saying is, don’t always take the easy route. If you see a fund that is basically a basket of other funds, be skeptical. It’s a shortcut and you might end up over-diversifying unintentionally.
Too Many Individual Stock Positions
Owning too many individual stock positions can be a surefire sign that your portfolio is over-diversified. After a certain point in time, each additional investment you make will bring in fewer and fewer returns (remember the law of diminishing returns).
Owning Privately Held, ‘Non-Traded’ Investments
Obviously, not all privately-held investments are bad. They’re often promoted for their price stability and diversification benefits compared to their publicly-traded counterparts.
Although they can provide you with diversification, you want to make sure you’re not holding any ‘alternate investments’ that are fundamentally no different from your publicly-traded investments.
A good example of this is if you own a bunch of physical real estate, it may not make a ton of sense to invest a large portion of your portfolio in REITs or other real estate-focused investments. Put that money somewhere else.
Maybe you’ve already made the mistake of over-diversifying. That’s okay. It’s not an irreversible process, and you can always turn around and make changes to fix your mistakes.
Whether you’re trying to bring your diversification levels down, take them up, or even if you’re just starting off with your investments, there are a number of things you should take a look at.
Determining Risk Tolerance
This is an important aspect of portfolio management that everyone who so much as dabbles into the financial market needs to consider.
What is your risk tolerance? Are you risk-averse, or do you have a tendency to go for risk?
Since all your present and future investments depend on your tolerance for risk, you need to be aware of the kind of return you desire. Higher risks mean higher returns, but investments are of varying kinds.
Risk tolerance is also not a static measure in itself and can change over time with age, market fluctuation, and economic conditions.
When you’re investing in many different securities, make sure you’re not adding an overabundant amount of high-risk stocks, as well as an excessive amount of low-risk stocks, so you’re equipped to receive maximum profits. In other words, find balance.
Long-Term Investment Outlook
While short-term profits look pretty attractive, it’s important to have a long-term goal in mind and stick with it. However, don’t be too rigid about your strategies, and keep an open mind to new ideas.
Asset Allocation and Reallocation
Once you have determined your risk tolerance and long-term investment goals, you need to categorize your investments to see where they fit in the ultimate plan of things.
You should know which stocks to buy for diversifying your investment and what their percentage would be in your overall stocks.
Determining what proportion of your portfolio will consist of what kind of asset is a good way to avoid over diversifying. For example, by deciding to allocate 30% of your investment portfolio to stocks, you can avoid going overboard when investing in stocks.
Since there are different kinds of assets, your portfolio can be relatively balanced. Of course, you also need to be mindful of not over diversifying within that allocation.
Quality Over Quantity
Holding too many individual stock positions is the same as holding a lot of fragments that don’t benefit you in any way. You may think that by investing in a lot of different stocks, you will be safe from losses during a general decline, but this is not the case.
The reality is that a majority of the stocks are sensitive to market conditions. A decline in the market will also result in a decline in these stocks, and if you’re holding a lot of market-sensitive securities, you will face losses ultimately.
Holding a very small portion of securities that were generating good returns in the past could make their contributions significant–or even nonexistent–in your investments. By having too many stocks in your portfolio, you are reducing the extent to which any security can outperform.
Since you can’t get rid of systemic risk, you are not only leaving yourself vulnerable to potential market downside moves but also killing your chances of outperforming the market.
How do you know what the optimal level of securities is? There is no fixed number, but personally, I think holding between 10 and 30 stocks can adequately diversify your portfolio.
Attention to Detail
Sometimes you’ll come across investment funds that look attractive at a glance but remember, all that glitter is not gold. You need to make sure the investments you make are not duplicates of others and don’t come bearing high costs.
Privately-held investments, for example, come with specific investment risks that may be understated because of the unconventional methods used to value them.
The values of many private investments, (like privately-traded real estate that I mentioned before) are based mostly on appraisal values and estimates, instead of on-market behavior.
Just like old cars need repairs, old portfolios need calibration. If something doesn’t fit into your investment plans, get rid of it.
Investments with narrow mandates, those that have a high cost or those that perform below par hurt overall returns. Hence, you must be quick in selling them off.
Similarly, you may have to make additional investments in assets that you are not exposed to or those that are high performing.
To beat the market, you will have to constantly study your portfolio’s performance and reorient the monetary allocation between the different classes of assets. Making sure that your portfolio is in line with the asset allocation that is suitable for your financial goals is essential.
Narrow your portfolio down to a few core investments that have consistently high performance.
At its core, over-diversifying is an attempt to minimize, and in some cases, eliminate risk entirely. As it is, you cannot completely get rid of risk, and over diversifying also ends up costing you more than it benefits you. Where there is no risk, there is no return, and over-diversifying is an excellent example of this.
Now, don’t go crazy and get rid of every stock you own. Find balance and do what works for you. But remember that just like you can under-diversify, you can over-diversify too.