When diversification is dangerous
Updated
August 28, 2024
Diversifying too much can make you lose money
Probably the most basic piece of investment advice that you’ll ever receive is to diversify your portfolio.
There’s a good reason for this. Almost no one picks winning investments all the time and diversifying is a way of reducing the damage that any poor choices might have on our funds.
But too much of a good thing usually doesn’t end well and, even if it's close to gospel for personal finance writers, this also applies to diversification.
Most explanations of the subject will eventually devolve into someone saying ‘don’t put all your eggs in one basket’.
That’s a simple way of describing diversification and it helps get across why it’s a good thing.
The problem is that it doesn’t capture exactly what investors are doing when they choose to hold multiple assets.
Diversification is effectively a balancing act.
You want to mix up your investments so that any losses you experience will be offset by the performance of your other holdings. The downside of this is that the reverse also happens — any gains you make will be held back by your other investments that haven’t performed as well.
What investors try to do is find a sweet spot where they are able to get the maximum return possible, while still being protected. But problems can begin if they go too much in the wrong direction.
An unfortunate habit that some investors have is to treat their portfolio rather like a sticker book and, as they get older, to keep adding more and more assets to their collection.
To be fair, this may not end up being a bad thing. There is still some debate as to what size the ideal portfolio should be.
Famous investor Benjamin Graham thought it was between 15 to 30 stocks but other researchers have come up with numbers far higher than that. And that doesn’t include other asset classes, like bonds or cash.
Regardless of this, what definitely does happen is that you lose the upside that your investments provide the more assets you add to your portfolio.
Imagine if you own one stock worth £10. If it goes up by 10% in value, your portfolio is worth 10% more. Now imagine you have 10 stocks all worth £10. That same stock goes up by 10% but the other 9 remain the same price. In that case, your portfolio is only increasing in value by 1%.
Such a scenario is unlikely to happen given that prices are constantly moving. You should also remember that the reverse is true — you could face a 10% loss or a 1% loss.
But the point remains that the more you add to your portfolio, the more you dilute your high-performing assets.
It also makes keeping track of what you’re doing really tricky. Managing the performance of 100 stocks, for example, isn’t easy to do.
Of course, one of the ways that people deal with this problem is by passing on the task of managing their money to someone else by investing in trusts and funds.
But over-diversification can also be a problem here too as you may be buying practically the same thing several times over.
For instance, if I bought shares in an S&P 500 ETF, the Alliance Trust and the Bankers Trust today, I’d be getting exposure to Facebook, amongst many other companies, on all three occasions.
That means that, in an effort to diversify your holdings, you can actually end up with a higher level of exposure to a certain company, industry or asset class than you intended.
The impact of this can be that you don’t hold quite the diversification you thought you did when, say, the technology sector takes a hit.
This generally happens when people only look at a trust’s performance or take a superficial glance at the sectors it's covering. Taking the time to see what you’re putting funds into won’t take long and it’s the easiest way to prevent this from happening.
Another potentially damaging impact of over-diversification is the higher fees that you may have to pay for having too broad a range of assets.
For stocks, this is increasingly less relevant given that so many companies, like Freetrade, have cut trading commissions, although there are still some FX costs to pay when you make trades in foreign stocks.
The bigger danger comes for investors that like to put money into lots of trusts.
What can end up happening is that you get a decent amount of exposure to a particular sector or country. That could include the US tech industry or the biggest UK companies.
If this does happen, your actual investment exposure may provide a good balance of risk and reward. But the array of trusts you hold could mean that you're paying much higher fees than you need to.
For instance, a UK stock market ETF will likely cost you far less than buying shares in several investment trusts that give you similar exposure.
Again, this can so easily be avoided by just making sure you know what you’re getting exposure to when you put money into funds.
None of this is to say that diversification is a bad thing, only that holding too many assets can make managing your portfolio hard and inefficient.
You can also make needless investments that hurt your ability to grow your portfolio’s value.
More importantly, investing in multiple funds can lure you into a false sense of security.
Not only could you end up being overexposed to certain sectors — the opposite of diversification — you could also waste your money on fees that you don’t need to pay.
So this is not us hating on diversification — we’re still big fans! It’s just a warning to make sure you’re doing it right.
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Important information
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
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