Diversification is a critical concept when assembling a risk-conscious investment portfolio. If you own a variety of investments, including several different types of investments, poor performance from one or more of them is less likely to depress the value of the entire portfolio.
So, it is tempting to conclude that, if diversification is a good thing, a lot of diversification is even better. Not so. Owning too many investments or spreading assets across too many asset classes can work against you.
Reducing Losses
Diversification is designed to reduce the impact of losses
that you might experience when certain asset classes, particular
market sectors or even the general market is struggling. While some
investments or asset classes lag, others may perform well, or, at
least, not as badly. Thus, diversification helps reduce the overall
volatility of your portfolio.
Although diversification helps manage risk, it will never keep your portfolio fully protected from losses. For example, in times of financial crisis, many investments or asset classes move in tandem and punish even well-diversified portfolios.
Encouraging
Mediocrity
Although the risks of underdiversification are relatively
clear, the negative implications of too much diversification may
initially be harder to see. However, there are several reasons why
owning too many investments or investment types can work against
your portfolio:
- Complexity
The more investments you have in your portfolio, the harder it can be to keep track of all of them. It is 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 is prudent to rebalance your portfolio or change your investment strategy to remain on target toward long-term financial goals. - Portfolio Overlap
Another potential risk of overdiversification 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, if you have two small-company growth mutual funds in your portfolio, the odds are good that they hold some of the same stocks. Not only does this mean that you are duplicating investment costs, but also that you are getting greater exposure to certain stocks than you intended. Bigger positions can seem like an advantage if those stocks are doing well; however, not if they stumble and make your portfolio more volatile. - Dilution
Research has shown that, at a certain 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 high-flyers become diluted by the average-to-poor returns of the portfolio's remaining investments.
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. However, the opposite is also true. If a single stock performs well, a less-robust second stock can limit overall portfolio returns. The challenge for investors is to limit risk while encouraging returns. So, while diversification is an essential investment tool, you need to use it wisely.
Optimal Number and
Type
Recognizing when you might have reached the point of
overdiversification is not always easy. That is where financial
professionals come in. Your advisor can help you determine an
appropriate number and type of investments so that diversification
strategies support — not undermine — your financial
objectives. However, as always, note that no investment strategy,
including diversification, can guarantee gains or prevent
losses.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.