In a perfect world, your investments would earn steady, guaranteed returns, year-in and year-out. but we do not live in that world. Instead, we practice diversification by putting money into a variety of different asset classes and investment types. Did you ever think about how much diversification is too much diversification?
Take stocks: They can provide big returns on your investment, but the risk is that they can and do lose value. There are, of course, risks that are beyond our control as investors. A pandemic, for example: If all of a sudden, the global economy is crushed by the outbreak of a highly contagious virus again, your entire portfolio will likely suffer. This is known as a systemic risk. War is another systemic risk that can potentially affect all companies and with it affect the stocks of the companies. Systemic risk cannot be mitigated but some risks can be mitigated through diversification.
Why is Diversification Important
Through diversification, you can compensate for risk to a certain level as your money is been distributed among several industries that may or may not be affected by the next fall in the market. When it comes to having a diversified portfolio, the conventional wisdom is pretty clear:
Don’t put all your eggs in one basket. Spreading our wealth across different investments, including over different asset classes and geographies can help us avoid the potentially unforeseen catastrophic risk that may arise from just a single investment. But you can have too much of a good thing, and diversification is no exception. There is a point where the cost of adding another investment to a portfolio can create a negative impact.
What Would Too Much Diversification Cost You?
“Diversification is a fundamental cornerstone of investing; however, it can be overdone,” said Faron Daugs, chief executive of Harrison Wallace Financial Group, based in Libertyville, Ill. “Owning stocks from each sector of the market is important in reducing the overall risk of the market to your portfolio, but be careful not to water things down too much.”
Major problems when you over diversify: –
- You might choose quantity over quality
It might happen that you choose an underperforming stock or industry that does not perform that well, just so you could diversify your portfolio but it would in return harm your portfolio as it would give you negative returns over time in the long term.
- You might risk losing sustainability & technology
You might invest very little in the industries that are and might perform really well in the future as they have huge growth potential but due to your rule of diversification you tend to only invest a very small part of your capital in these industries.
- It might reduce your portfolio return
As an investors risk profile is so diluted in the process of diversification & spread so thin across all the major industries that it cannot bring in a good amount of profit from one particular sector and performs average across all industries.
So How Much Diversification is Enough?
There’s no absolute cut-off point that distinguishes an adequately diversified portfolio from an over-diversified one. As a general rule of thumb, most investors would sufficiently diversify a portfolio as one that holds 20 to 30 investments across various stock market sectors. However, others favor keeping a larger number of stocks, especially if they’re riskier growth stocks.
Few will disagree that diversification is a good thing. Investors should be wary, however, not to overreach in their pursuit of diversification. For the vast majority, hitting the right risk is likely 90% of the battle. Introducing diversification just for diversification’s sake can lead an investment plan off course. Instead, investors should diversify with a purpose, mitigating those risks they aren’t compensated for bearing while leaving exposure to the asset classes and active strategies that drive long-term portfolio growth.