Diversification is a common problem for the majority of investors. In most cases however, the primary dilemma is either inadequate diversification, or a complete lack of it. But there is an opposite extreme that’s not much less risky, and that’s being too diversified with your investments. How do you know if you’re too diversified?
Though that doesn’t seem possible on the surface, a closer look not only reveals how this happens, but also what the risks and costs are that are associated with it.
Here’s what you need to know about diversification to strike the perfect balance.
1. Are You Paying Too Much in Fees?
In a perfect portfolio, you have your money divided between three or four mutually exclusive asset classes (which is not at all easy to do), and then further split among several securities and/or funds within each asset class. This might see you holding a total of 30 to 40 individual securities and funds in a medium-size portfolio.
But if you are too diversified, you may be holding 60, 80 or even 100 or more individual securities and funds within your portfolio. Not only is that a lot of holdings in an individual investment fund, but it also represents a whole lot of transaction fees.
In most cases, you’ll have to pay a transaction fee in order to acquire any position within your portfolio. The more positions you have, the more fees you’re paying. That will have the effect of reducing the return on your portfolio, which can have a substantial impact on your long-term investment goals.
If you’re sensing that you’re paying too much in transaction fees to maintain your portfolio, it may not be that the broker you’re working with is too expensive, but rather that you are buying and holding too many securities.
2. Are You Consistently Underperforming the Market?
The biggest weakness related to diversification — and the reason why so many investors are so reluctant to implement it to any serious degree — is that diversification tends to lower investment returns during rising equity markets.
Diversification is a trade-off between minimizing risks in bear markets, and being able to take full advantage of bull markets. That’s all part of the process of diversification.
But if you’re finding that your performance is well below the general market, it could be an indication that you’re too diversified. For example, if the S&P 500 returned 20% in the last 12 months, but your portfolio came in at 10%, over-diversification could be the culprit. This may not be a problem at all if you’re 65 years old and getting ready for retirement, since you probably have at least half of your portfolio invested in low-risk assets. But if you’re 35 years old when you’re trailing the market by that margin, excess diversification probably has something to do with it.
3. Do You Have Unintentional Duplicate Holdings?
One of the purposes of diversification is to spread your investments within each asset class, so that a significant decline in a small number of securities doesn’t bring down your entire portfolio — or at least the slice you have in that particular asset class. But if you are trying to avoid this fate by holding multiple funds within the same asset class, you may be defeating the entire purpose.
It’s most likely that funds invested in the same asset class all have a very similar portfolio mix, one that includes many of the same individual stocks. That means that though you’ll spread your money across several funds, you are essentially ending up with the same mix of securities.
In effect, you will increase the risk in the asset class, since the collapse of just two or three securities could bring down several funds at once, without meaningfully increasing the return you will receive on the upside.
The only way to truly diversify within an asset class is to make sure the positions you have are truly different from one another.
4. Are You Spending Too Much Time Managing Your Portfolio
Portfolios that are too diversified are truly hands-on affairs. Just monitoring your positions can be quite involved, but periodic rebalancing could be worse than preparing a complicated income tax return.
If you find yourself spending too much time managing your portfolio, you may be too diversified. You may need to cut down the number of holdings that you have, so that you have more time to take care of all the other things that life requires.
At some level, an investment portfolio can be liberating; if you feel yourself tethered to it, the portfolio may be too complicated as a result of over-diversification.
5. Has Your Portfolio Stopped Being Consistent?
Even if you have a certain predetermined methodology to maintain diversification within your portfolio, it’s important to recognize that like everything else, diversification reaches a point of diminishing returns.
If diversification is the driving force in your portfolio management strategy, you may find quickly than you end up with a hodgepodge of funds and securities, that collectively lack any sort of consistency. Diversification can often be a strategy of adding a little bit of this, and a little bit of that, but to no constructive end.
Like everything else connected with investing, and in life in general, there has to be a limit on how far you go with it. And so it is with diversification.
You want to be diversified sufficiently to protect your portfolio against a worst case scenario. But at the same time, you don’t want to be so diversified that your portfolio is incapable of participating in bull markets in any meaningful way.
Readers: Do any of these questions bring to light the fact that you may be too diversified?