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Is it possible to over-diversify a portfolio?

Most financial advisors eventually bring up the topic of diversification to their clients. This topic is discussed by every source of financial media. However, there comes a point in financial analysis where everyone should ask if they have been over-diversifying there portfolio.

The idea behind making a portfolio of investments diversified is to bring down your risk tolerance. If you have your assets spread out over many different sectors, the less risk you have of every asset in your portfolio being hit in a downturn.

However, there are some people that would argue a word of caution when doing this. Read on to see some interesting thoughts about why it is possible to over-diversify and affect your return.

The main thought I have here is that I see a barbell effect happening. Investors seem to be either on one end of the spectrum or the other.

Most investors seem to want to put all their money in a retirement account like a 401k and never worry about it. Alternatively, others want to manage it themselves but can’t help but seek out the companies that still have a lot to prove. These companies are usually young and are forecasting major growth in the early future.

The problem is that no one knows what the future will hold and this does not play in the favor of new companies.

This is why it is important as a stock investor to find a balance with your portfolio. Still, I will argue that over-diversifying can be harmful just like only seeking out high growth stocks.

In this post, I will describe the following topics on over-diversifying a portfolio.

• Fees associated with diversification
• An overabundance of investments to track
• Over complicating the process

1. Paying fees associated with diversification 

Often times, when a manager or investor aims to diversify a portfolio they invest in an abundance of asset classes. These may include: stocks, bonds, mutual funds, ETFs, money market funds, real estate and even things like derivatives. Derivatives include things like options, futures or currencies. 

The amount of investment vehicles out there has increased substantially over the years. According to Investopedia.com, ETF’s alone have become one of the most popular asset classes to invest in. The first one was created in the 1990s.

If you think about it, that’s not very long ago. Now we also have items like cryptocurrencies to invest in.

The point is that only recently have we had so many options to diversify our portfolios with. However, the more asset classes there are to invest in, the more fees there are for a financial advisor or fund manager to collect.

It is true that trading costs and expense ratios have come down. An expense ratio is the percentage of a funds assets that are used for expenses for managing that fund (aka paying the manager). However, the truth is that although costs have come down, the investment selection has gone up. These two factors have come to offset each other.

With the amount of money that our federal government has printed over the last two decades, there is a ton of money that has flowed into the financial sector. This has made it easier for money managers and firms to create more financial assets that collect more fees. 

Most fees associated with investment funds range between 1-5%. According to Forbes, the difference in a single percentage point can affect the final value of your investment portfolio by hundreds of thousands of dollars. 

Every time a fund manager decides to adjust the funds assets there are fees involved. This is called a funds turn over ratio. Therefore, the more active a fund is the more costs are usually associated with that account. 

Overall, the truth about managing a portfolio of investments is that the more asset classes a portfolio holds, the more fees can be associated with it. Owning a portfolio of stocks does not cost you anything unless you sell an investment.

One of my favorite teachings from Warren Buffett is his idea of a punch card. The idea is that every young investor should have a punch card that can only hold 20 punches. Over the course of your life, these are the only investments you get to make. The methodology behind this lesson is that if those are the only investments you get in a lifetime, you will think very hard about each one.

As you can imagine, 20 investments is not many. However, I would be willing to bet that you would think very hard about them and you will save money for going against the grain and not over-diversifying your portfolio. 

2. Having an overabundance of investments to track

One of the first questions I ask myself when I see other portfolios is how are they keeping track of every single investment?

According to Warren Buffett, “wide diversification is only required when investors do not understand what they are doing.”

Many professional stock investors and analysts are good at their job. With that being said, there comes a point where it becomes hard to pay close enough attention to every investment you own.

I would much rather buy 3-5 stocks that are great businesses and have lasting potential than I would 25 stocks and have some mediocre businesses involved. In a portfolio of 25 stocks, the chances of you investing in some great and some horrible stocks is likely. Anything more than 25, you might as well buy a fund and let someone else manage your money.

Most people would probably ask how hard it would be to select 3-5 investments and know they are great picks. The truth is that finding a great business is not hard to do. 

The definition of a great business is one that makes more money than it consumes. Not to mention other things like developing a product that strengthens society by supplementing our lives. However, for the sake of this post the first definition will suffice.

So where do you go to find great businesses? The Dow Jones industrial average. Or how about the S&P 500?

The Dow Jones is an exchange where the United States top 30 stocks trade. According to The Motley Fool, the companies in the Dow are worth a combined 5 trillion dollars and have a combined profit of 325 billion. These numbers are also from 2014 which means they are worth even more today.

In summary, the Dow Jones is a great starting place to find an individual stock worth investing in. The best thing an investor can do is find an investment they understand and be prepared to hold it for a long time.

The idea is not to refrain from diversifying at all, but to make sure that we don’t overcompensate our number of allocations just to say we are diversified. 

3. Making the process complicated

At the end of the day, the goal of investing is to make money.

I love to ask the question: If we are over-diversifying our portfolios, are we getting away from the goal we wanted in the first place?

It may be true that you can eliminate some risk by spreading out your capital. Yet, if this only limits your risk by a couple of percentage points, is it worth it?

According to Investopedia.com, In Edwin J. Elton and Martin J. Gruber’s book Modern Portfolio Theory and Investment Analysis, if you invest in more than 20 stocks you only eliminate an additional 2.5% of risk. That means that investing in 100 stocks does not give you an aversion to risk the way most people think.

It’s true that beyond a portfolio of roughly 20 stocks, most investors are only complicating the process. 

If investors would only focus on a few investments and become engaged in the process of understanding those investments, then most would find a return that satisfies them. 

In Charlie Mungers book Poor Charlies Almanack, He explains a human bias called Influence-from-Mere-Association Tendency. 

The bias essentially explains how humans will attach to something just because it is associated with something already popular. Do we diversify our portfolios only because that’s what everyone tells us to do?

Furthermore, it is easy for investors to get caught up in endless data collection. I know this from experience. As someone that wants to do their best to make a solid return, it is easy to try and memorize all the data about a particular investment.

However, instead of over complicating the process of stock selection, focusing on the factors that make a business great will lead to success.

To help with not over complicating your investment selection I would focus on the principles mentioned here.

Sometimes doing nothing in your portfolio is okay. As humans we think we always need to be making moves. If we don’t do anything we feel like we aren’t working enough.

The truth is that the market does not always offer great investments. By slowing down and engaging in our investment selection but not over-diversifying our portfolio, we can earn a solid return.

Here are some tips for finding great companies to invest in:

• For example: Do you think people will stop using their cell phones? Cell phone providers may be a great investment.

2. Does the company make money? 

• I know people want to find the next Apple. But the truth is that it is very hard to spot a company like this early on. It is better to find a company that has already left its mark and try to get shares at a fair price.

3. Does the company have a history of solid management? Or has there been litigations in the past?

• Companies that have a competitive advantage and a large moat will be able to last a long time regardless of who runs them. Yet if a company has a history of doing some funny business, maybe that is not the best choice.

4. Does the company have a lot of debt?

• This may seem like a bit too specific, but a company that is piled with debt will have a much harder time making it through a bear market than one that does not. Also check for the amount of cash on hand. This never hurts either.

5. Is the investment selling at a reasonable price?

• Every investment can be a bargain. The only question you have to ask yourself is: Am I getting good value for my money?