Everything You Must Know About Over-Diversification

While generally, all investors would swear by the benefits of diversification in a portfolio, it is very critical to understand the thin line between diversification and over-diversification. It is easy to be overwhelmed by the influx of capital gains and reduced risk and make that momentary mistake of stretching the diversification strategy to the far-end. However, the result of such an action is not the maximization of gains. Instead, it causes marginal losses of a potential return to exceed the marginal benefits of the minimized risk. This ultimately jeopardizes the primal objective of investment to maximize income. Hence, it is very crucial for an investor to know when to pull back from diversification, not cross the greener pasture, and ultimately be left with the barren returns.

Here is all you need to know about over-diversification:

Understand and identify over-diversification

Over diversification refers to a portfolio that stretches beyond the optimal level of diversification. Owing to this strategy, an investor ends up with too many stocks in the portfolio, resulting in increased costs, higher complexity, minimal risk-adjusted returns, and loss of high-performing assets. Adding a new stock does reduce the overall risk but also simultaneously lowers the returns. Such as, for a person who holds more than 600 different stocks, the risk is very low, but the overall risk-adjusted earnings will be lesser, since the portfolio will miss capturing high-performance stocks.

That said, it is very easy for an investor to cross the thin line between optimal diversification and fall prey to over-diversification. However, with these easy ways, one can identify when it’s time to pull back:

1. Holding excessive mutual funds in a sole investment style

A common mistake that tends to exceed the limit of diversification is investing too much in the same investment style. Most mutual funds have similar holding and strategies despite having different names. If an investor holds too many stocks in a particular investment class such as large-cap funds or mid-cap funds, there is a high chance of over-diversification. Thus, it is critical for an investor to identify and understand the background holding and strategies of each mutual fund before investing. This can be easily done by choosing to spread the investment over different types of mutual funds rather than laying all in one. Ideally, investing in more than one mutual fund in a specific style attracts higher costs, causes complexity, and typically nullifies the benefits of diversification.

2. Hugely impacted investments with slightest market changes

Another critical indicator of over-diversification is when an investment portfolio is completely shaken even with the slightest of changes in the macro-environment such as false news, negative publicity, change of management, etc. There is no measure of how much change is acceptable, but one must weigh the event against the fluctuation in their portfolio and assess if the impact is rational.

3. Owning too many individual stocks

Ideally, there is no set rule as to how many individual stocks are considered ideal for diversification but crossing the set mark certainly causes extensive stress, a complex tax situation, and a poor performing portfolio. As per research, an individual investor can have a maximum of 300 stocks to be optimally diversified. It is also known that it requires 20 to 30 varied companies to diversify the portfolio favorably. However, irrespective of the number, the core is to understand that a constructively diversified portfolio should have investments across companies and industries while ensuring that the ultimate goal of the investor is not compromised.

Drawbacks of over-diversification

While many would preach the theory of diversification to gain the maximum benefits from an investment, the theory can fiercely backfire when the ideal limit is exceeded. Here are some of the most significant disadvantages of over-diversification:

1. Diluted returns

Even though you might be spreading the risk of the portfolio, excessive diversification will result in lower than expected returns. This is because there are only a limited set of high-quality stocks that offer the required benefits to the investor. Hence, to gain more returns, the investor will put money in mediocre, average, and below-average performers that will ultimately reduce the overall earnings since it misses out on the best-performing stock opportunities.

2. High transaction costs

A major drawback of over-diversification is the increased costs such as bank fees, fund manager charges, brokerage fee, expense ratio, etc. Every diversification move adds a cost to the portfolio that simultaneously affects the overall earnings prospects.

3. Inferior investment vehicles

It is well-known that diversifying the portfolio beyond certain limits implies that investments are being driven in index funds or actively traded mutual funds. These investment vehicles deliver below-average returns in the long run since their focus is only on a short period instead of adding value.

4. Indexing

Crossing the ideal limit of portfolio diversification can turn the fund into more of an index fund, which is a low long-term performer. If the goal is to purchase an index fund, buying one directly will be cheaper than investing in multiple stocks which replicate it and add costs to the investor.

5. Duplication

Duplication or inefficient diversification is a possible disadvantage of over-diversification. The main aim is to spread the risk and returns over varied sectors. However, if you own too many stocks, this will ultimately concentrate more than required stocks in a sector. Thus, resulting in duplication and lowering returns.

6. Complex management and tracking

Too many stocks cause management complexities, which ultimately lead to loss of certain high-gaining opportunities. Tracking every fund in terms of quarterly reports, annual statements, corporate announcements, recent news, etc., becomes a very daunting task and one which if not performed well, can cause a huge financial setback to the portfolio.

Tips to ensure ideal diversification

It is fundamental to understand the perils of over diversifying but also very important to know how to ensure the ideal level of portfolio dispersion. Here are some easy tips:

1. Prefer quality over quantity

The investment aims to not raise the number of stocks but to maximize income and minimize risks. While diversification does help to reduce risk, exceeding the ideal limit can cause the returns to go even lower than expected. Hence, one must always prefer to invest in quality stocks which have high ratings with affordable risks but promise elevated returns.

2. Study the funds

An investor must make choices based on an in-depth analysis of the funds, in terms of the company’s annual returns, latest news, expected changes, etc. No investments must be made merely to spread risk and without proper consideration. An extensive study of returns against risk appetite for each investment must be made.

3. Relocate more often

Investing in multiple stocks can cause the portfolio to become excessively bulky. This is not only harmful to the returns but also causes increased management complexity. Hence, one must study the portfolio consistently and keep relocating assets between classes, which is possible only with limited investments.

To sum it up

Over-diversification can cause a serious dent in investment gains. Therefore, an investor needs to know when to pull back from spreading the risk too far to avoid it from negatively affecting the earnings. One must be consistently aware of the stocks, study the funds, and update the portfolio to stay within ideally diversified limits. You can also seek help from financial advisors to ensure there is no overstepping.