Avoiding Over-Diversification
Diversification involves having a wide range of investments within a portfolio to reduce risk – basically, not having all of your trading eggs in one basket. Having a range of investments usually yields higher returns, and also shields an investor from losing everything if one part of the market falls.
But did you know that you can be over-diversified? Not only that, but some financial advisers encourage it.
You may be over-diversified if you:
• Own too many mutual funds within a single investment style category
• Excessively use multi-manager investments
• Own excessive individual stock positions
• Own privately-held, non-traded investments that are no different to the publicly traded investments you own
Too many mutual funds in a single category
A mutual fund is a pool of funds collected from a number of investors for the purpose of investing in financial instruments, such as stocks and bonds. However, some mutual funds with different names can have similar investment strategies and investment holdings.
Investment research firm Morningstar has developed categories for mutual funds, such as ‘large cap value’ and ’small cap growth’, which group similar mutual funds. Investing in more than one fund in the same category reduces the rate of diversification achieved by holding multiple positions, while increasing your required investment due diligence and investment costs.
Excessive use of multi-manager investments
Multi-manager investment products, like mutual funds that invest in other mutual funds, can help small investors obtain instant diversification. However, these products have a lack of customisation, as well as high costs and diluted due diligence, with a financial adviser monitoring an investment manager who is monitoring other investment managers.
Excessive individual stock positions
Too many individual stock positions can result in high levels of required due diligence, complicated taxes, and performance that mimics a stock index (but which costs more than it would to trade on that index).
It is widely accepted that it takes around 20 to 30 different companies to adequately diversify a stock portfolio (though there are varying opinions on this), and these stocks should be invested in companies across different industry groups and should match an investor’s trading style.
Privately-held, non-traded investments like the publicly traded investments you own
Non-publicly traded financial products are promoted for their price stability and diversification benefits when compared to publicly traded products. Although these products can diversify your portfolio, their risks may be understated by the irregular methods used to value them (such as estimates and appraisal values rather than market transactions), which can artificially smooth an investment’s return over time. This smoothing can overstate a product’s diversification benefits by understating its volatility and correlation relative to more liquid assets.
Additionally, if these products are similar to the publicly-traded ones you have already invested in, you lose the benefit of diversification.
Why is over-diversification encouraged?
In the case of the man on the street, he probably doesn’t recognise over-diversification. In the case of your financial adviser, it comes down to job security and revenue.
If a financial adviser fears losing accounts over unexpected investment outcomes, this could motivate him to diversify your investments to the point where they don’t move in either direction. And, with mutual funds, it is easy for the adviser to spread your portfolio to other investment managers. And, over-diversifying your portfolio could help an adviser earn more in fees and charges for individual investments.
So, the lesson to take from this is to actively work with your financial adviser – ensure that you understand everything in your investment portfolio, why you own it and how it contributes to your investment strategy and goals. Becoming involved in the diversification process is the best way to both hedge your portfolio and make it perform to its greatest potential.
