You may have heard that diversification is the golden rule of investing. And while it certainly is an important part of risk management, there are times when it can go too far. A good diversification strategy can help investors reduce the risk of owning individual stocks, but it is possible to have too much of a good thing. Over-diversification can end up reducing a portfolio’s returns without meaningfully reducing its risk.
What Is the Danger of Over-Diversification?
Over diversifying your portfolio can distract you from the overall picture and ease you into thinking that quantity in your investment mix is more important than quality. It can also become complicated to analyze the impacts of each investment on the portfolio, meaning it may be difficult to ensure your portfolio mix aligns with your risk tolerance. When you have too many factors influencing the performance of your portfolio, you may not be able to determine what is driving your return, which in turn makes it difficult to make informed decisions about your future investments. So how do you know how much portfolio diversification is too much? Here are four things to look for.
4 Signs of Over-Diversification
You Have Multiple Mutual Funds in the Same Investment Style Category
Each mutual fund is classified by an investment style, such as “small cap growth” and “large cap value,” that groups together mutual funds with similar assets, risk and investment strategies. Investing in more than one mutual fund in the same category increases how much you pay for your portfolio to be managed without giving you the benefits of diversification.
The Number of Individual Stocks You Have Creates a Management Burden
When you have too many individual stocks, the expense of managing those stocks and the burden of the required due diligence for taxes is more costly than the additional stocks are worth. Research shows that there is little difference between owning 20 stocks and 1,000, as the benefits of diversification and risk reduction are minimal beyond the 20th stock.
You Rely Heavily on Multimanager Investments
Multimanager investments products (such as funds of funds or feeder funds) can add instant diversification to your portfolio. However, overuse of this strategy means that you have a financial advisor who is monitoring an investment manager who is monitoring more investment managers.
You Own Privately Held “Non-Traded” Investments That Are the Same as Your Publicly Traded Investments
While privately held investments are advertised as more diverse and less risky, the valuation methods used are complex. Be sure to clarify how its risk/reward differ from the publicly traded investment you already own — the two may not be as different as you think.
The Goldilocks Level
In general, when you add complexity to your portfolio without decreasing risk or increasing your returns, you are over-diversified. To get to the right level of diversification, where you’re protected and reaping the benefits of a diversified portfolio, contact a Farm Bureau financial advisor