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.
Great question for sure. I believe most do over-diversify. I wish I still had the study I read many years ago so I could share it. It showed that once you go past 25 stocks, you really don't gain the benefits of diversification for the equity portion of your portfolio. If you do what everyone does, you get what everyone gets.
Hope that helps!
As far as investing mistakes go, over-diversifying probably doesn’t make the list. That said, the benefits of adding asset classes diminish after a certain point. In addition, the weight of each impacts their efficiency. Our research suggests about a dozen asset classes with the smallest no less than 3%, is about right for a large investment portfolio.
What I see more often is an investment portfolio that may have dozens of holdings, but little diversification. The holdings will consist of mutual funds, ETF’s individual stocks and bonds, but when aggregated and analyzed, we find lots of overlap. On the surface ,the portfolio looks diversified, but in actuality, it’s very concentrated with large gaps. There are portfolio analyzer tools to help determine if this is the case. Morningstar’s X-Ray tool is a decent one.
I hope that helps.
You ask an interesting question. It all depends on what you mean by the term, “diversification.” You mention ETFs, mutual funds, and stocks but owning lots of these does not mean that you are diversified.
Diversification means that you are spreading the risk of loss by putting assets in several categories of investments. Examples include stocks, bonds, money market instruments, precious metals, and real estate. Within each of these categories, you can slice even finer. For example, stocks can be classified as large cap, mid cap, small cap, domestic, and foreign. And within each of these categories, you need to look at industry diversification.
Too many retail investors believe that if they own a number of different mutual funds, they are diversified. This is true only to the extent they are more diversified than someone who only owns one company’s stock. But those funds may own many of the same stocks.
You need to look at a “portfolio x-ray” which will show you how much overlap there is between two or more mutual funds.
Only by looking at your portfolio with this view of diversification can you get an answer your question.