Investment Must-Knows

When Diversification Becomes Over-Diversification—A Negative Trade-Off

Investing in a single stock is proverbially putting all of your eggs in one basket. If your one stock performs well, you earn big. If it stagnates, you earn nothing. If it drops, you might lose everything. The better approach is to diversify, spreading your investment across a variety of stocks or investments to attempt to reduce your exposure to investment specific risk. That way, the impact of a loss is ideally offset by gains elsewhere.

Over-diversification may, however, be just as damaging as failing to diversify. Owning too many investments can ultimately negate the positive effects of diversification, resulting in inefficient risk management and decreased return potential.

Optimization is necessary. Here’s how it works:

Quality Is More Important than Quantity

After your first 10 stocks, the potential reduction of company specific investment risk in your portfolio offered by adding an additional stock is marginal.1 Investing more dollars in a smaller number of stocks also allows the opportunity for high-performing stocks to have a greater impact on your bottom line. Conversely, investing less in a larger number of stocks in the hopes of reducing company specific risk might actually diminish those potential returns—a negative trade-off sometimes referred to as “diworsification.”2

A well-diversified portfolio, regardless of its size, usually contains investments from a variety of companies, sectors, industries, and countries, meaning they will respond to market events differently. (It is important to note that diversification only attempts reduced exposure to company or investment specific risk. Market and systemic risk cannot be reduced by further diversification in that market or system.)

Similar and Under-Performing Investments Hold You Back

Consider funds. Mutual funds, often comprising 150 or more investments, may not always be as diversified as you think. Some are sector-specific, offering holdings in a variety of companies within the same industry or similar ones.3 Many benchmark their performance to an index and are constructed with the goal of providing performance similar to their benchmark index. Plus, if you invest in several mutual funds, you may end up owning overlapping investments or investments that are vulnerable to the same risks.

Indexed funds that hold what the index is made up of like an S&P 500 index fund or Russell 2000 index fund hold even more stocks (in this case 500 or 2000 companies). By investing in the S&P 500, you get shares in all of the high-performing companies but all of the under-performing companies as well. The positive and negative growth cancel each other out, creating an averaging effect with mediocre returns. Rather than just invest your money in the winners and the losers, why not work with a financial advisor to try to develop a portfolio of winners?

How Financial Advisors Can Help

Picking the right advisor is important. Advisors who employ dozens of funds or many funds of funds in addition to multiple funds and ETFs may be over diversifying and should get a thorough review.

In addition to diversifying your stock, advisors can assess how to diversify your portfolio across a mix of assets that could include bonds, cash, commodities or real estate – not only stock and bond funds. Cash and gold typically help mitigate loss in times of stress and yet many advisors rarely recommend those two asset classes.

An advisor can also help diversify your approach, setting up several investment buckets that employ different combinations of assets and strategies (conservative, moderate, and aggressive) to suit your long- and short-term financial goals.

There are ways to be tactical in an attempt to mitigate some risk; if you can move into cash from time to time. We can all plan to do that. For some it will require a change in mindset and a change to their current strategy.

As advisors we have to be much more in tune with how the markets are moving and where to find growth even if it’s in small spurts because the volatility is keeping portfolios stagnant in many cases.

Here are seven signs you may need an Optimization Checkup:

  1. You own only Mutual Funds
  2. You Own Only ETF’s
  3. You Own Only Mutual Funds and ETF’s
  4. You’ve heard of Most of the Stocks you Own (You know the name because the companies are large
  5. You Own Bond Funds not Bonds
  6. You have no Cash or very little in your investment accounts
  7. You Don’t Own Physical Gold or Silver

Give yourself a higher priority. Put your investment checkup on your to do list today. And then get an optimization checkup. It’s important.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing.

All performance referenced is historical and is no guarantee of future results.

All indices are unmanaged and may not be invested into directly. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.

Diversification does not protect against market risk. Investing in mutual funds involves risk, including possible loss of principal.

An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.

Because of its narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The fast price swings in commodities and currencies will result in significant volatility in an investor's holdings.

Investing in real estate involves special risks such as potential illiquidity and may not be suitable for all investors. Investing involves risk including loss of principle. No strategy assures success or protects against loss.

References

  1. Statman, Meir. "How Many Stocks Make a Diversified Portfolio?" The Journal of Financial and Quantitative Analysis22.3 (1987): 353. Web.
  2. Allison, D. (2011, January 27). Top 4 Signs Of Over-Diversification. Retrieved March 15, 2017, from http://www.investopedia.com/articles/financial-theory/11/signs-of-over-diversification.asp
  3. Staff, I. (2016, July 01). The Dangers Of Over-Diversifying Your Portfolio. Retrieved March 15, 2017, from http://www.investopedia.com/articles/01/051601.asp
  4. Statman, Meir. "How Many Stocks Make a Diversified Portfolio?" The Journal of Financial and Quantitative Analysis22.3 (1987): 353. Web.

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