There is no doubt that throughout the course of your investing career – no matter how long or short that career has been – you have heard of the value of diversification in investing. “Don’t put all your eggs in one basket,” experienced financial analysts will warn, “you don’t want to take on too much risk at once.” As you likely already know, diversification is a highly-touted strategy for reducing unforeseen risk in your investment portfolio by investing in many different kinds of investments at once. As the logic goes, if one of your risky investments fails, the rest of your investments might help your portfolio to better survive the fall.
However, in all the talk about the value of diversification and investing in many different asset classes at once, investors often overlook the fact that it is possible to over-diversify their portfolios. Just as the term shows, over-diversification is the act of taking diversification too far – investing in too many different things and passing the point where adding another investment adds benefit. In fact, there is even a point where adding an additional investment to your portfolio could come with some costs. In this article, we will explain some of the possible costs that an investor might incur by over-diversifying his or her portfolio.
1. Lack of Focus
One of the most important powers that we have as investors is our ability to discriminate between different investment choices. We can choose whatever companies or investments that we think are best and complete all of the necessary research to develop those investments decisions until we are ready to jump in. But, by over-diversifying our portfolios, we could get to a point where we forfeit the ability to control our decision-making. Many investors whose portfolios are over-diversified tend to feel as though they repeatedly get stuck on the minute details of their portfolios (of which there are many) instead of focusing on the big picture and hand-picking the exact investments they want.
2. Lack of Understanding
Not only can over-diversification compromise our ability to focus on the most important aspects of our portfolios, but it can also make it difficult to fully understand the investments that we are making. Think about it in other terms: while it might be simple for you to remember one of your favorite recipes when you’re making dinner, it is likely much more difficult for you to read and remember the entire cookbook from which that recipe came. The same is true of stocks: when we are familiar and have done our research on an investment, it becomes easy for us to understand. But, if we look at 25 different investments all at the same time, chances are we will understand each one less and less as the days pass.
3. Quantity versus Quality
In the chaos that comes with over-diversification, other investors have found that they miss out on choosing quality investments because they are geared towards picking so many investments at a time. Furthermore, just because an investor picks a large number of investments doesn’t mean that his or her portfolio is diversified. For example, an investor could invest in 10 different airline companies, but not have a diversified portfolio – because all of those investments are from the same asset class and the same industry. Remember: diversification is a science and must be carefully planned to work functionally. To find quality investments that work together in reducing your overall risk, quantity may not always be the most important factor to look for.
4. Long-Term Sustainability
Finally, with the issues we have addressed above, it makes sense that an over-diversified portfolio could sacrifice long-term sustainability. An investor must fully understand his or her own investments and strategy in order to maintain portfolio sustainability over time. Further, without fully understanding his or her existing investments, an investor could end up introducing more risks into his portfolio without even realizing the consequences.
As investors, it is only natural for us to want to avoid these detriments to our own portfolios. By understanding the investment decisions we make – and by understanding the limits to diversification – we will be much better able to do so! Check back next week for an article which will describe some of the most common signs that your portfolio could be headed towards over-diversification!