Is it possible to over-diversify my portfolio?
I've always made an effort to diversify my portfolio to achieve long term growth and protect myself from losing money. However, I am wondering if there is such a thing as over-diversification of my portfolio. What is a sign that I am, in fact, over-diversified? Would over-diversifying between ETFs, mutual funds, and stocks hurt my invest goals and the value of my of portfolio in any way, and if so, how?
Yes, it may. It is probably less dangerous than being under-diversified, but too many investments can have too many fees and probably more importantly, too tough to manage. When I coordinate all of my client's assets, I see how they work historically together, meaning their risk and return profile, liquidity, and taxes. An asset in one account may go up when another goes down. I look at how they performed when things got tough, like 2009. I then add in my view as if they will look like that in the future.
This can still be done with a lot of different assets, but it is more difficult.
The other thing to consider is overlap. Do they both have the same assets? If they do, you might not be as diversified as you think.
Take a close look at your investments. If you have the interest, this is certainly something you can do yourself. You could also hire an hourly planner with better software to take a close look. Many of us can be found at www.NAPFA.org.
Keep asking questions. Inquisitive people like you have a greater chance of building wealth!
Mark Struthers CFA, CFP®
Diversification has long been a risk reduction strategy used by investors. Mutual funds and ETFs are logical investment choices for those who want to get maximum diversification because they are already structured to include a diversified set of holdings, consistent with whatever investment strategy the fund is employing. All funds have some sort of management fee which will, over time, subtract from total returns.
Individual stock ownership, unless it's part of a very large portfolio, generally causes a portfolio to be concentrated. Most portfolio managers hold that a position which exceeds 5% of total holdings is a deduction from diversification. If one wants to build a diversified portfolio of individual stocks, it should include at least 20 issues, spread across the 10 industry sectors most commonly used to segment the market: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Materials, Real Estate, Technology and Utilities.
An additional tactic used by knowledgeable investors is asset allocation. This is the use of not only diversifying tools, like funds, but spreading the ownership of those funds over numerous portions of the investment universe so that Large Cap, Mid Cap, Small Cap, Domestic and International, Equities, and Bonds are all represented in the portfolio.
Diversification reduces risk, but it also tends to push returns to the mean. And, remember, fees subtract from returns. Comparing your return to an appropriate benchmark will allow you to see, in a relative sense, how you are doing. If your goal is to beat the market, risk taking, by either concentrating your holdings or trading is a necessary tactic to employ, but while risk taking can lead to better returns, it can also lead to bigger losses. You should know what your risk tolerance is before you adopt a more aggressive investment strategy in search of higher returns.
There is an ironic tidbit about diversification in today's day and age. Before index ETFs were so prevalent, investors would achieve diversification through buying a number of stocks (or bonds), so that one bad performance by one single company couldn't crush your whole portfolio. Today, with the wide availability of low-cost index ETFs, buying more securities doesn't diversify you more, and you can in fact be maximally diversified by holding just a few tickers. It is counterintuitive, but here is an illustration:
Portfolio 1: 50% in a total US stock market index fund, 30% in a total all-world ex-US stock market index fund, 20% in an aggregate bond fund. ***Total tickers/securities held: 3
Portfolio 2: 10% in a portfolio of 20 individual stocks (0.5% each), 10% in the utilities sector fund, 10% in the technology sector fund, 10% in the US small cap fund, 10% in the emerging markets fund, 10% in a developed market Europe and Far East fund, 10% in the US large cap fund, 5% in the REITs fund, 10% in long-term treasuries fund, 10% in intermediate term corporate bonds fund, 5% in short-duration fixed income fund. ***Total tickers/securities held: 30
Portfolio 2 has way more securities, but is actually less diversified. Why? Because there are these individually concentrated bets on individual sectors and stocks, while Portfolio 1 is broadly allocated to thousands of stock and bond issues that are underlying the index funds themselves.
I see this in people's portfolios all the time. Rather than just buy the broad index funds, they feel they are diversifying literally by buying more tickers/securities. It's a fallacy and a value-destroying behavior. Bear in mind that concentrated sector funds that are not simply doing passive sampling of broad-based indexes tend to have higher fees than the broad index funds. Plus, you are having to do more trading to buy and sell a greater number of securities. For all these reasons, for long term investors seeking maximum diversification, I typically advise a very simple, streamlined portfolio of just a handful of tickers (all index funds). It may seem a little scary to have so much concentration in just a small number of tickers, but these broad index funds represent ownership in thousands of underlying securities and are very well diversified in a one-stop shop.
So to answer your question directly, yes. Not only is it possible, it is a common mistake.
In answer to your question, you are probably over-diversified if you have more than a couple of dozen holdings. That will have a negative impact. It will increase your costs, require far too much time monitoring where you stand, and keep you from having a sharper aim at your investment objective.
This is a particularly interesting question for me since I have a client whose actions would certainly come under the heading over-diversification. When I first met him, he had more than 120 different holdings, including mutual funds and individual stocks. I shudder to think of the recordkeeping involved.
Diversification is a critical issue because it responds to the concern about putting all of one's eggs in one basket. One of the key objectives of proper investing is to achieve worthwhile returns while reducing fluctuations along the way. The way to do that is to have investment funds spread among a variety of asset classes. This is done because different asset classes generally move in different directions. The technical term is non-correlation, which means that some asset classes move up while others are moving down. A well-diversified portfolio is one where there's sufficient non-correlation to reduce volatility significantly below that of the market averages.
One example is stocks and bonds. The average annual long-term return from stocks is about 10%; bond returns are about half that. But bonds are far less subject to fluctuation than stocks, which is why they are usually included in portfolios of investors with time horizons of less than 20 years. And in 2008, when almost every asset class went down dramatically, bonds held their own.
To get a handle on whether your portfolio is over-diversified, you might begin with an evaluation of your asset allocation. How much is in equities, how much is in fixed income, and how much is in alternative investments? Without knowing your personal situation, I can't say more about where those percentages should be. But the next step would be to review the funds, ETFs, and stocks to determine where the duplication of underlying holdings is.
The client I referred to above had 15 different energy stocks. That was excessive, especially since they could be replaced with one ETF focused on energy. Similarly, if you have major funds, you should be aware that they have to focus on the same highly liquid stocks, so it's likely that you have duplication there as well.
My suggestion; define your asset allocation, identify and eliminate duplications, and focus on low-cost ETFs and funds. By doing so, your task will be easier and less time-consuming, and you will be more flexible in your ability to keep improving your portfolio over time.
It is very possible to over-diversify a portfolio. The purpose of diversification is to reduce your investment risk while only marginally decreasing your return potential. The risk can be defined by standard deviation which is the volatility of your portfolio.
For example, if 10 years ago, you invested your entire portfolio in one stock, Apple, you would have had an average annual return of 26.39% with a standard deviation of 61.13%. This means that with a 95% probability, we could assume that the return for this stock in any calendar year could fall between -95.87% and 148.65%. Although Apple has had a great return over the past 10 years, that is A LOT of volatility to deal with.
Now, let's say you add in another stock to your portfolio in a completely different industry, South West Airlines. South West Airlines had an average annual return of 12.94% over the past 10 years and a standard deviation of 50.44%. When you combine these two stocks into one portfolio, investing the portfolio evenly between the two, you come out with a 10 year average annual return of 23.66% and a standard deviation of 40.88%. This means that in any given year, you can expect a 95% probability that your portfolio's return will range between -81.536% and 82%. By giving up a little less than 3 percentage points of return each year, you decrease your risk by 14 percentage points. As you continue to add non-correlated stocks to your portfolio in different industries, size, and countries, your risk continues to diminish much faster than your return.
However, research has shown that after about 20 different positions, your risk no longer decreases, but your return does. So yes, over-diversifying could hurt your investment goals because you could be potentially be reducing your return for no additional benefit of reducing your risk.
This is how I would determine if you are over-diversified and how to correct it:
First, just do quick overview of your portfolio. Break up the positions in your portfolio into different asset classes. Use these asset classes to start, U.S. Large Cap, U.S. Mid Cap, U.S. Small Cap, International, Emerging Markets, Alternative (Real Estate & Commodities), Long Term Bonds, Mid Term Bonds, Short Term Bonds, TIPS, and Money Markets. Right there you have 11 different asset classes. Once you have categorized each of your positions, reduce your investments to 1 or 2 in each asset class. If you are using a fund (ETF or Mutual Fund) to represent an asset class, I would only own one fund for that class. If you are using an individual stock to represent an asset class, it might be better to choose 2. This will naturally put your portfolio around 11 - 22 positions.
If you want to get deep into the analytics, you can use Excel to calculate your average annual return over a certain historical time period and then use those returns to determine what your standard deviation is, or the amount of risk your investments are subject to in terms of volatility.
I think it's important that you have diversified your portfolio, just make sure you aren't over-doing it!