Over-diversification could actually hinder your investment goals
Investment and Asset Management
Diversify, diversify, diversify. If you know only a little about investing, you’ve almost certainly heard — perhaps more times than you’d care to — about the importance of building a diversified portfolio. But is it possible to over diversify or spread your investment dollars too thin across asset types and industry sectors? In a word: Yes. But because diversification is a complicated concept and can be difficult to get right, you need a nuanced perspective.
Why do we do it
Diversification is designed to reduce the impact of losses that you might experience when specific securities or asset classes, particular market sectors, or even the general market are struggling. While some investments or asset classes lag, others may perform well — or not as badly. Thus, diversification helps reduce overall portfolio risk and volatility.
But while diversification helps manage risk, it can never keep your portfolio fully protected from losses. For example, in times of financial crisis, many investments or asset classes (including in some periods, both stocks and bonds) can move in tandem and punish even well-diversified portfolios. The bottom line: When you invest, there’s always a risk you’ll lose a significant portion of your original investment.
An overlooked risk
Although the risks of under diversification are relatively clear, the risks of having too much diversification may initially be harder to see. But there are a couple of reasons why owning too many investments or investment types can work against your portfolio.
First, the more investments you have in your portfolio, the harder it can be to keep track of all of them. It’s more challenging to monitor each investment’s performance and understand when something fundamental has changed with individual stocks or mutual funds. Consequently, you may not know when it’s prudent to rebalance your portfolio or change your investment strategy to remain on target toward long-term financial goals.
Another potential risk of over-diversification is holding overlapping securities. The more individual investments you own, the greater the likelihood that you may not be as diversified as you think. For example, there’s a good chance that two small-company growth mutual funds own some of the same stocks. If you own both funds, you not only duplicate investment costs, you also get greater exposure to certain stocks than you probably intended. Bigger positions can seem like an advantage if those stocks are doing well — but not if they stumble and make your portfolio more volatile.
Also consider multiple studies that have shown that, with a certain higher level of diversification, investment portfolios tend to produce consistently mediocre returns. This happens because, when you have a large number of holdings, the returns of the successful ones become diluted by the average-to-poor returns of the portfolio’s remaining investments. Meanwhile, you may be paying fees that aren’t justified by diluted returns.
Optimal number and type
To review, a portfolio of two stocks is less risky than a single-stock portfolio because performance problems with one security can be offset by the other security’s higher returns. But the opposite is also true. If a single stock performs well, a second stock can limit overall portfolio returns. The challenge for investors is to limit risk while encouraging returns.
What, aside from becoming an investment expert, can you do to assemble a balanced portfolio? Work with your Lenox advisor. We can help identify the goals that are most important to you — for example, reaching a certain amount by the time you retire while reducing tax exposure — and build a portfolio that targets these goals.