Diversification: How much is too much?

Economist Harry Markowitz once said, "Diversification is the only free lunch in investing". And he was right. But can too much diversification give your portfolio indigestion? We think it can. 

Diversification is best known by the phrase, "don't put all your eggs in one basket". The wisdom behind this is that if we put all our eggs into one basket, and that basket drops, all we're left with is broken eggs. 

In the same way, if an investor puts all their money into just a handful of companies, and one or two of those companies fail, they can lose a small fortune.  

As such, diversification is like the ultimate backup plan, in that it protects us from stock, sector, geographic, and asset-class-specific risk. 

So, how is it possible to over-diversify? To answer this, we'll first look at what a well-diversified portfolio looks like. 

A well-diversified portfolio 

The following is an example of a well-diversified portfolio. (This is the mix of ETFs included in InvestSMART's Conservative, Balanced, Growth and High Growth portfolios.) Please note that I haven't included any asset allocations, as that depends on the investor's risk profile. 

The above portfolio contains an enormous amount of built-in diversification. This includes: 

• Diversification in companies: IOZ contains shares in 200 of the largest companies in Australia, and VGS contains 1,500 of the largest companies in the world. VAP and IFRA also provide exposure to numerous companies. 
• Diversification in sectors: Within IOZ and VGS, all sectors are represented, including financials, materials, energy, healthcare, and information technology. 
• Diversification in geographies: IOZ and VAP hold Australian shares, while VGS holds shares from 23 developed countries. IFRA also holds infrastructure shares from 20 developed countries. 
• Diversification in asset classes: The portfolio is diversified across all the major asset classes including Australian shares, international shares, bonds, property, infrastructure and cash. 

The above portfolio also contains an enormous amount of quality. For example, when you buy the IOZ ETF, you are buying 200 of the biggest companies in Australia, that are on average, well-managed, well-capitalised, profitable, and operate within mature and established markets. 

What is over-diversification?

Over-diversification occurs when too many investments are added to a portfolio which might add diversification but in the process increases risk and lowers returns.

One way to check whether over-diversification is occurring is to ask yourself whether the new investments are improving or worsening the risk-to-reward trade-off in the portfolio. In other words, are they adding more risk than rewards?

There are two main ways an investor can over-diversify their portfolio. The first is adding investments that are either already in the portfolio or provide the same function as existing holdings. This may lead to overlap in the portfolio or increased fees. 

The second is adding higher-risk investments, such as tech startups, cryptocurrencies, currencies, commodities, emerging market stocks, leveraged ETFs, short-sold stocks, options, and penny stocks. Though owning these investments may increase the diversification in your portfolio, they may also lose you money, which will ultimately reduce the portfolio's returns. 

What are the risks of over-diversification?

There are several reasons why over-diversification can be bad for your portfolio. These include:

• Quality. When you over-diversify, you often stray into assets that are low quality. 
• Risk. Investing always comes with some risk, but if you invest in assets that you don't fully understand, it could result in taking on a lot more risk than you realise. 
• Fees. Buying complex financial products almost always comes with higher fees. Adding more fees to your portfolio will lower returns, and eat into your long-term wealth.
• The portfolio becomes unwieldy. Too many holdings in a portfolio can make a portfolio hard to manage. This can result in you losing track of the risk, fees, and overlap in the portfolio. An unwieldy portfolio is also difficult to manage at tax time. 

5 tips to avoid over-diversification 

Here are five simple tips to help keep your portfolio in balance: 

1. Make sure your portfolio is simple, manageable and avoid complexity. 
2. Stick with the major asset classes and get your asset allocations right. Use low-fee broad-based ETFs. 
3. Never buy an investment that you don't understand. Always be willing to forgo an investment if the risks are too high. 
4. Ensure any new investment is in line with your financial goals. 
5. Always seek financial advice if you are unsure whether an investment is right for you. 
    

Ready to start investing? InvestSMART has a range of diversified portfolios that all come with a capped management fee. If you'd like help selecting the right style of portfolio for you check out our free statement of advice quiz. It will show you which InvestSMART ETF portfolio may best suit your goals and investment timeframe.