Can an investment portfolio ever be too diverse?
Can you over-diversify a portfolio? Yes. Holding 50 stocks rather than 25 may lower your downside risk somewhat, but it can also reduce your profit potential. And at that point, it may be better to consider investing through an index fund, or even a combination of several sector-based funds.
The biggest risk of over-diversification is that it reduces a portfolio's returns without meaningfully reducing its risk. Each new investment added to a portfolio lowers its overall risk profile. Simultaneously, these incremental additions also reduce the portfolio's expected return.
Below Average Returns
Indexing and over diversification are disadvantages of diversification because quality suffers when you own inferior investments along with good investments. Below average returns result from transaction fees or high mutual fund fees.
The largest benefit of a diversified portfolio is that it can help minimize risk from market volatility. As an example, both stocks and bonds are subject to market fluctuations. By having a mix of each, you may offset potential downturns when one isn't performing as well as the other.
A classic diversified portfolio consists of a mix of approximately 60% stocks and 40% bonds. A more conservative portfolio would reverse those percentages. Investors may also consider diversifying by including other asset classes, such as futures, real estate or forex investments.
Make sure you keep yourself to a portfolio that's manageable. There's no sense in investing in 100 different vehicles when you really don't have the time or resources to keep up. Try to limit yourself to about 20 to 30 different investments.
Financial-industry experts also agree that over-diversification—buying more and more mutual funds, index funds, or exchange-traded funds—can amplify risk, stunt returns, and increase transaction costs and taxes.
- diverting funds and resources into diversification may limit potential growth in core areas of your business.
- lack of knowledge or expertise in the new industry or market may lead to costly delays or mistakes.
- diversifying too quickly may cause you to lose track of or dilute your core products or services.
Diversifying investments is touted as reducing both risk and volatility. While a diversified portfolio may lower your overall risk level, it also reduces your potential capital gains. The more extensively diversified an investment portfolio, the more likely it is to mirror the performance of the overall market.
Although diversification helps mitigate the risk of investing, it comes with some limitations. Higher risk of investing in wrong securities: With a plethora of investment options available in the market, you tend to get confused and might end up investing in the wrong securities.
Does a diversified portfolio beat the S&P 500?
Just because one asset class is doing well or poorly at any given time doesn't mean you should include or exclude that asset class from your portfolio. A diversified portfolio might outperform or underperform an index such as the S&P 500, which only measures U.S. large cap stocks, on any given day, quarter or year.
To be truly diversified, investors need to own a collection of assets with different risk drivers, which will act and react differently from each other.
This would be your interest-based return if you built a 100% bond portfolio overnight. In the long run, if you were to only invest in AAA corporate bonds over time, you can expect a modern yield between 4% and 5%. Historic rates have been higher, sometimes up to 15%, leading to a 30-year average of 6.1%.
An ideal diversified portfolio would include companies from various industries, those in different stages of their growth cycle (e.g., early stage and mature), some companies from foreign countries, and companies across a range of market capitalizations (small, mid, and large).
This rule is a popular investment strategy that helps investors determine how much risk they should take on based on their investment goals and risk tolerance. Essentially, the rule states that a well-diversified portfolio should never have more than 5% of its capital invested in a single stock or security.
Experts with the Motley Fool suggest allocating an even higher percentage to stocks until at least age 50 since 50-year-olds still have more than a decade until retirement to ride out any market volatility.
Many financial advisors recommend a 60/40 asset allocation between stocks and fixed income to take advantage of growth while keeping up your defenses.
Go for Variety, Not Quantity. Having a lot of investments does not make you diversified. To be diversified, you need to have lots of different kinds of investments. That means you should have some of all of the following: stocks, bonds, real estate funds, international securities, and cash.
Diversification is also important. For the stock portion of your portfolio, Sullivan recommends about 70% in U.S. stocks and 30% in international stocks, with a mix of large, mid-sized and small cap equities. (For more portfolio help, try this asset allocation tool.)
A good diversification strategy can help investors reduce the risk of owning individual stocks, but it is possible to have too much of a good thing. Over-diversification can end up reducing a portfolio's returns without meaningfully reducing its risk.
What are common mistakes that investors make in portfolio diversification?
Diversifying your investments is an important part of any investment strategy. However, it's important to avoid common mistakes like not understanding your risk tolerance, over-diversifying, not considering correlations, not rebalancing your portfolio, and ignoring fees and expenses.
It's a good idea to own a few dozen stocks to maintain a diversified portfolio. If you load up on too many stocks, you might struggle to keep tabs on all of them. Buying ETFs can be a good way to diversify without adding too much work for yourself.
Diversification is a key principle of portfolio management. It is the practice of not putting all of your portfolio's eggs in one basket. And its importance can often be forgotten due to specific biases we all can fall victim to.
More focused companies are often easier to manage and possess a clear, strategic goal – something that can be lacking with diversified firms. “One of the main reasons that diversification fails is because businesses do not have the right strategy in place,” Shipilov said.
It can help you increase your revenue, reduce your dependence on a single source of income, and create a competitive advantage. However, diversification also comes with some risks, such as higher costs, complexity, and uncertainty.
