7 Reasons Why Being Too Diversified Can Hurt Your Investments
Diversification is good for an investment portfolio, right? That’s the conventional wisdom, but can your investments be too diversified? As the saying goes, too much of anything isn’t good and this principle applies to diversification, just as it does with virtually everything else in life.
There are a host of reasons why being too diversified with your investments can hurt your chances of building wealth for the future.
1. Accumulating Too Many Assets
In any given investment sector, there are generally no more than a small handful of good companies. This means if you're diversifying into dozens of different stocks in a sector, it is entirely likely you are loading up on stocks that are less than top performers.
That kind of asset accumulation can feel comforting on an emotional level, but it is virtually counterproductive as an investment strategy. The lower performers are dragging down the returns from the better companies. In such a scenario, your return on investment will probably be better if your exposure in the sector was limited to maybe eight or 10 different companies, rather than 20 or 30.
2. Paying Higher Fees for Multiple Holdings
The more securities you hold in your portfolio, regardless of the purpose, the more you’ll be paying in transaction and investment fees. This can take a significant bite out of your investment returns, even if most of the stocks you hold are high performers. But when you combine high fees with mediocre or low performance, the negative impact is magnified.
3. Over Complicating a Relatively Small Portfolio
While it may be possible — but not desirable — to achieve broad diversification with a multimillion-dollar investment portfolio, the same generally cannot be said of a much smaller portfolio. If you try to diversify with a portfolio of say $100,000, you’ll be forced to maintain very small positions in each company.
This may reduce the potential loss you sustain from the decline of any one stock, but it will also lower your gains. After all, a large return on a small position will generally result in a relatively small return. Multiplied across your portfolio, this can result in below-market level returns on your portfolio overall.
4. Funds in the Same Sector Cancel Each Other Out
Many investors diversify by holding multiple funds within the same investment sector. While this may be an honest effort to achieve diversification, it usually fails at a very fundamental level.
If you look at the funds in any given sector of the market, what you’ll generally see is that each fund holds pretty much the same stocks. This is hardly unusual. Investment managers have access to all the same information their competitors do and often reach the same conclusions about individual companies. In addition, any stocks that are deemed to be winners in the sector, will be virtually an automatic hold by any fund in the sector.
For example, if you’re looking to diversify by holding several funds in the technology sector, and each one of those funds has substantial positions in Apple, Intel, and Microsoft, what you are achieving is duplicate diversification — which is no diversification at all.
When it comes to funds, especially actively managed mutual funds, it’s important to remember the fund itself represents a portfolio of stocks and other securities. If you’re holding more than two or three funds in any investment sector, you’re adding needless levels of diversification to your portfolio.
5. The Law of Diminishing Returns
The law of diminishing returns also applies to diversification. While some diversification is good, particularly across several different investment sectors or asset classes, too much diversification within a particular sector or asset class is likely to have the opposite effect. It's even possible to diversify your portfolio into oblivion — the point at which you’re mostly just holding a large collection of securities that’s so convoluted it underperforms the market.
Simply getting into a large number of companies within a sector does not achieve true diversification. You’ll be far better off investing in a relatively small number of highly successful companies within that sector. After all, the best returns will be provided by the strongest companies.
6. A False Sense of Security
One of the worst aspects of being too diversified is that it can lull you into a false sense of security. You can reason that since you have so many individual securities in your portfolio, you will be less likely to suffer much loss in a general market decline or might even miss the decline entirely. That can even cause you to make investment mistakes, based on an exaggerated sense of stability in your portfolio.
No matter how many securities or funds you add to your portfolio, the reality is most securities are market sensitive, which is to say they will decline with the rest of the market. The fact you are holding scores or even hundreds of individual securities will not change this dynamic.
7. An Investment Management Nightmare
Even if a high level of diversification could improve your investment returns, it’s still creating an investment management nightmare. You’ll have more stocks and funds to manage, more buy/sell decisions to make, more rebalancing, more trades, and the many fees that come with all that extra activity.
In addition, if your portfolio includes multiple mutual funds in each sector, you will have far less control over your capital gains situation. Each actively managed mutual fund will have capital gains, and that will create a tax liability on your part. The fact that you have many mutual funds reporting many capital gains events will make it much more difficult to properly manage the tax implications of your investments.
To achieve a level of diversification that will help you to minimize your investment risk, it’s perhaps best to limit the number of stocks in any given sector to no more than 10, or the number of funds to not more than two or three. Any holdings beyond that could be a strong indication your investments are too diversified.
I can see the point on most of the examples you listed. The one I most agree with is number 7. I’ve set some rules for my portfolio where one is “A position can’t weigh larger than 20% or smaller than 5% of the total portfolio”. I have 2 reasons for that:
1. I’m making sure that I only have the absolute top quality companies in my portfolio.
2. I make it easier for me to keep myself updated of these companies. I believe it’s better to have a complete understanding of a few companies than being somewhat updated of a lot of companies.
I currently have 12 companies in my portfolio. Even though I can technically allow up to 20 because of my 5% rule, I feel comfortable to have around 10-15 where stronger companies that I see have better potential weigh a bit higher.
All in all, good article on a subject that isn’t discussed very often. I see a lot of portfolios with 30-50 companies out there, which is OK if you have the time to make sure they are of good quality and keep yourself updated.
I think you’re on the right path. Based on the numbers, it looks like most of your holdings are on the smaller end, toward 5% of the portfolio. This is just my opinion, but I think 20% in any one investment is a bit heavy, even for a strong company. After all, even strong companies sometimes slip on a banana peel, and sometimes they don’t recover for years. Wouldn’t you be better off keeping the strongest positions to not more than 10%? (Though it looks like your average holding is 8.3%, since your portfolio holds 12 positions.)