Diversification is frequently recommended by financial experts as a crucial portfolio management tool. Diversification is a tried-and-true strategy of lowering investment risk when done correctly. However, too much variety can be detrimental and lead to diversification.
Initially identified as a company-specific problem in Peter Lynch’s book, One Up On Wall Street (1989), the term diversification has evolved into a buzzword used to characterize ineffective diversification as it relates to a whole investment portfolio.
Owning too many investments, like a ponderous corporate conglomerate, can be confusing, increase investing expenses, add layers of required due diligence, and result in below-average risk-adjusted returns.
Why Do Some Advisors Excessively Diversify?
Job stability and personal financial gain are two incentives that may push a financial advisor to over-diversify your investments. Blending in as an asset manager can provide the most job stability. That is, they do not try to excel because they are afraid of underperforming and losing clients.
Fear of losing accounts due to unanticipated investment outcomes may drive an advisor to diversify your investments to the point of mediocrity. Furthermore, financial innovation has made it relatively simple for financial advisors to spread your investment portfolio among a variety of “auto-diversification” products, including funds of funds and target-date funds.
Outsourcing portfolio management to third-party investment managers involves very little work on the advisor’s behalf and can present them with opportunities to point fingers if things go wrong.
Finally, the “money in motion” associated with over-diversification might generate revenue. Buying and selling investments with different packaging but comparable core investing risks offers little to diversify your portfolio, but these transactions frequently result in greater costs and additional commissions for the advisor.
Having Too Many Funds That Are Identical
Some mutual funds with quite diverse names can have relatively similar investment holdings and overall investment strategies. Morningstar created mutual-fund-style categories like “large-cap value” and “small-cap growth” to assist investors cut through the marketing hoopla. These categories put mutual funds that have fundamentally comparable investment holdings and strategies together.
Investing in more than one mutual fund within any style category raises investing expenses, increases the amount of due diligence necessary, and diminishes the rate of diversification provided by holding numerous investments. Cross-referencing Morningstar’s mutual fund style categories with the various mutual funds in your portfolio is a quick method to see if you have too many investments with comparable risks.
Be skeptical of consultants that advocate for what you may perceive as excessive diversification, as the reason is most certainly financial.
Excessive Use of Multimanager Products
Multimanager investment vehicles, such as funds of funds, can provide small investors with quick diversification. If you are nearing retirement and have a larger investment portfolio, you are usually better suited directly diversifying across investment managers. When evaluating multimanager investment products, compare the benefits of diversity against the lack of customization, high prices, and layers of diluted due diligence.
Is it truly in your best interests to have a financial counselor overseeing an investment manager who, in turn, oversees other investment managers? It’s worth remembering that at least half of the money involved in Bernard Madoff’s famed investment fraud came to him through multi-manager investments such as funds of funds or feeder funds. Many of the investors in these funds had no knowledge that an investment with Madoff would be buried in the maze of a multimanager diversification scheme prior to the fraud.
Having an excessive number of individual stocks
An excessive number of individual stock positions can result in massive amounts of required due diligence, a confusing tax situation, and performance that merely duplicates, albeit at a higher cost, a stock index. A commonly acknowledged rule of thumb is that 20 to 30 diverse companies are required to fully diversify your stock portfolio. However, there is no apparent agreement on this figure.
Benjamin Graham recommends in his book The Intelligent Investor (1949) that owning between 10 and 30 diverse companies will sufficiently diversify a stock portfolio. In contrast, Meir Statman’s 2004 essay “The Diversification Puzzle” in the Financial Analysts Journal argued that “today’s optimal level of diversification, evaluated by the criteria of mean-variance portfolio theory, exceeds 300 stocks.” The essay updated Statman’s earlier work from 2002, in which he called for at least 120 stocks, and from 1987, in which he advocated for 30 to 40 stocks—all of which reflect the stock market’s expansion over the last few decades.
A diverse portfolio, regardless of an investor’s magic number of stocks, should be invested in companies from several industry groupings and should reflect the investor’s general investment philosophy. For example, an investment manager claiming to enhance value through a bottom-up stock-picking approach would struggle to justify having 300 fantastic individual stock ideas at the same time.
Having Assets That You Don’t Understand
Privately held, non-publicly listed investment products are frequently recommended for their price stability and diversification advantages over publicly traded counterparts. While these “alternative assets” can provide diversity, the complex and irregular methodologies employed to value them may understate their investment risks.
Many alternative assets, such as private equity and non-publicly traded real estate, are valued using estimates and appraisals rather than daily public market transactions. This strategy of valuing known as “mark-to-model” can artificially smooth an investment’s return over time, a process known as “return smoothing.”
Alan H. Dorsey writes in his book Active Alpha: A Portfolio Approach to Choosing and Managing Alternative Investments (2007), “The concern with smoothing investment performance is the influence it has on smoothing volatility and possibly affecting correlations with other types of assets.” Return smoothing can overestimate an investment’s diversification benefits by understating both its price volatility and correlation relative to other, more liquid investments, according to research.
Do not be deceived by how complicated valuation methodologies can impact statistical measurements of diversification like as price correlations and standard deviation. Non-publicly traded assets might be riskier than they appear and necessitate specialist knowledge to evaluate. Before you buy a non-publicly traded investment, ask the individual recommending it to show you how its risk-reward profile differs fundamentally from the publicly traded products you already possess.
In conclusion
Many “new” investment products with old investment dangers have resulted from financial innovation, while financial advisors rely on increasingly sophisticated statistics to gauge diversification. As a result, you should be on the lookout for diversification in your investment portfolio. Working with your financial advisor to understand what is in your investment portfolio and why you possess it is an important step in the diversification process. Finally, you’ll be a more devoted investor.