How much diversification is too much?


Is there such a thing as being too diversified?

Diversify, diversify, diversify! It’s the call of the modern investment advisor. Risk management strategies allow you to protect yourself from large losses by placing your investments in different asset classes, funds, geographies or stocks.

While one asset class may perform better than another in a given year, a diversified portfolio will provide fairly consistent returns over time.

“Diversification has hurt you this year, as emerging markets and international markets have not done well,” says Brian Face, of Face2Face Financial Planning. “But for the average investor, if you diversify properly, diversification will be a smoother ride over the long term.”

Here are some ways to determine if you’re getting what you want from your diversification strategy.

Diversification can be cheaper

“If you’re not diversifying, you’re not investing, you’re gambling,” says Roger Healy, director of Hibernian Financial Planning.

“You can’t overdo this,” he says. Additional investments in your portfolio will increase your diversification, ultimately reducing your risk of the same return or increasing your return on the same risk.

However, he says, the ‘over-diversification’ problem arises when you increase complexity without reducing risk or increasing return. This will also increase your cost in the form of additional fees.

Keep it simple, he says, and buy wholesale diversification at a lower cost through mutual funds or ETFs.

“You probably need more than 30 well-chosen stocks to have a diversified portfolio, but it’s cheaper to buy a basket of all 500 stocks in the S&P index, so save time and money and buy the index,” Healy says.

Diversification is a strategy that kicks in after your asset allocation, he adds. Buy a basket (or baskets) of securities in proportions that make sense for your risk tolerance.

Layoffs are not diversified

Many believe that the point at which over-diversification occurs is when a portfolio has more than 20 stocks, says Samuel Wieser, an investment adviser at Northman Financial. But it’s not just about the gross investment amount you have.

“Buying stocks, bonds, mutual funds and ETFs doesn’t necessarily mean you’re diversifying,” he says. “You can hold five ETFs or mutual funds that track the S&P 500 and you’re no more diversified than holding one of them.”

Since they all track the same index, they will all have very similar, if not identical, returns over time. Proper diversification involves buying a mix of stocks in different sizes, styles, sectors and regions of the world.

And just because you have funds with multiple managers (like TD Ameritrade, Vanguard, Fidelity and Charles Schwab) doesn’t mean you’re diversified. In the end, you might end up investing in similar funds and just pay more in fees.

Check your work

The most common way to gauge whether holding two or more stocks will diversify your portfolio is to look at the correlation between their historical returns, says Weiser.

“A key mistake that many make when looking at correlation is that they use a static figure,” he says. “You can go through periods where two stocks are highly correlated and others where they’re relatively uncorrelated. So if you look at the correlation over the last 12 months or the last 36 months, it can be misleading. It’s a better view. Look at the sustained correlation over a long period of time.”

Alternatively, you can see the returns on your property over time, says Weiser. “Many will grow together or decline together, but you’re probably over-diversified in the long run if they grow and shrink at the same rate.”

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CNNMoney (New York) Posted October 4, 2018: 1:58 pm ET