Diversify! Diversify! Diversify! Financial advisors love to recommend this portfolio management technique, but are they always looking out for your best interest when they do? When executed properly, diversification is a time-tested method for reducing investment risk. However, too much diversification, or "diworsification," can be a bad thing.
Initially described in Peter Lynch's book, "One Up On Wall Street" (1989), as a company-specific problem, the term diworsification has morphed into a buzzword used to describe inefficient diversification as it relates to an entire investment portfolio. Just like a lumbering corporate conglomerate, owning too many investments can confuse you, increase your investment cost, add layers of required due diligence and lead to below-average risk-adjusted returns. Read on to learn why financial advisors may have an interest in overdiversifying your investment portfolio and some of the signs that your portfolio may be diworsified. (See also: Choosing Quality Mutual Funds.)
Why Some Advisors Choose Overdiversification
Most financial advisors are honest and hard-working professionals who have an obligation to do what is best for their clients. However, job security and personal financial gain are two factors that could motivate a financial advisor to overdiversify your investments. (See also: Introduction to Investment Diversification.)
When giving investment advice for a living, being average can offer more job security than attempting to stand out from the crowd. Fear of losing accounts over unexpected investment outcomes could motivate an advisor to diversify your investments to the point of mediocrity. Also, financial innovation has made it relatively easy for financial advisors to spread your investment portfolio over many "auto-diversification" investments, like funds of funds and target date funds. Farming out portfolio management responsibilities to third-party investment managers requires very little work on the advisor's part and can provide them with finger-pointing opportunities if things go awry. Last but not least, the "money in motion" involved with overdiversification can create revenues. Buying and selling investments that are packaged differently, but have similar fundamental investment risks, does little to diversify your portfolio, but these transactions often result in higher fees and additional commissions for the advisor. (See also: Do You Need a Financial Advisor? and Finding the Right Financial Advisor.)
Top Signs of Overdiversification
Now that you understand the motives behind the madness, here are a few signs that you may be undercutting your investment performance by overdiversifying your portfolio:
- Owning too many mutual funds within any single investment style category: Some mutual funds with very different names can be quite similar with regard to their investment holdings and overall investment strategy. To help investors sift through the marketing hype, Morningstar developed mutual-fund-style categories, like "large cap value" and "small cap growth." These categories group together mutual funds with fundamentally similar investment holdings and strategies. Investing in more than one mutual fund within any style category adds investment costs, increases required investment due diligence and generally reduces the rate of diversification achieved by holding multiple positions. Cross-referencing Morningstar's mutual fund style categories with the different mutual funds in your portfolio is a simple way to identify whether you own too many investments with similar risks. (See also: Understanding the Mutual Fund Style Box.)
- Excessive use of multimanager investments: Multimanager investment products, like funds of funds, can be a simple way for small investors to attain instant diversification. If you are close to retirement and have a larger investment portfolio, you are probably better off diversifying among investment managers in a more direct manner. When considering multimanager investment products, you should weigh their diversification benefits against their lack of customization, high costs and layers of diluted due diligence. Is it really to your benefit to have a financial advisor monitoring an investment manager that is, in turn, monitoring other investment managers? It is worth noting that at least half of the money involved in Bernard Madoff's infamous investment fraud came to him indirectly through multimanager investments, like funds of funds or feeder funds. Prior to the fraud, many of the investors in these funds had no idea that an investment with Madoff would be buried in the labyrinth of a multimanager diversification strategy. (See also: Fund of Funds—High Society for the Little Guy.)
- Owning an excessive number of individual stock positions: Too many individual stock positions can lead to enormous amounts of required due diligence, a complicated tax situation and performance that simply mimics a stock index, albeit at a higher cost. A widely accepted rule of thumb is that it takes around 20 to 30 different companies to adequately diversify your stock portfolio. However, there is no clear consensus on this number. In his book "The Intelligent Investor" (1949), Benjamin Graham suggests that owning between 10 and 30 different companies will adequately diversify a stock portfolio. In contrast, a 2003 study done by Meir Statman titled "How Much Diversification is Enough?" stated, "today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 300 stocks." Regardless of an investor's magic number of stocks, a diversified portfolio should be invested in companies across different industry groups and should match the investor's overall investment philosophy. For example, it would be difficult for an investment manager claiming to add value through a bottom-up stock-picking process to justify having 300 great individual stock ideas at one time. (See also: The Dangers of overDiversifying Your Portfolio.)
- Owning privately held 'non-traded' investments that are not fundamentally different from the publicly traded ones you already own: Non-publicly traded investment products are often promoted for their price stability and diversification benefits relative to their publicly traded peers. While these "alternative investments" can provide you with diversification, their investment risks may be understated by the complex and irregular methods used to value them. The value of many alternative investments, like private equity and non-publicly traded real estate, are based on estimates and appraisal values instead of daily public market transactions. This "mark-to-model" approach to valuation can artificially smooth an investment's return over time, a phenomenon known as "return smoothing."
In the book, "Active Alpha: A Portfolio Approach to Selecting and Managing Alternative Investments" (2007), Alan H. Dorsey states that "The problem with smoothing investment performance is the effect it has on smoothing volatility and possibly altering correlations with other types of assets."
Research has shown that the effects of return smoothing can overstate an investment's diversification benefits by understating both its price volatility and correlation relative to other, more liquid investments. Do not be fooled by the way complex valuation methods can affect statistical measures of diversification like price correlations and standard deviation. Non-publicly traded investments can be riskier than they seem and require specialized expertise to analyze. Before purchasing a non-publicly traded investment, ask the person recommending it to demonstrate how its risk/reward is fundamentally different from the publicly traded investments that you already own. (See also: Learn the Lingo of Private Equity Investing and Alternative Assets for Average Investors.)
The Bottom Line
Financial innovation has created many "new" investment products with old investment risks, while financial advisors are relying on increasingly complex statistics to measure diversification. This makes it important for you to be on the lookout for "diworsification" in your investment portfolio. Working with your financial advisor to understand exactly what is in your investment portfolio and why you own it is an integral part of the diversification process. In the end, you'll be a more committed investor, too. (See also: Managing Risk and Diversification.)