They say that diversification is one of the critical golden rules for investments. The principle of not putting all your eggs in one basket is based on common sense. Diversification often reduces risks, but on the other hand, if you over-diversify your portfolio, it can reduce your potential return. This blog explains why over-diversifying a portfolio can sometimes be counterproductive and how one can strike that perfect balance.

Understanding Diversification

Understanding how to diversify your portfolio involves knowing the act of investing in more than one asset to reduce risk exposure. Proper diversification ensures that one poor choice in investing would not seriously crimp the value of a portfolio. However, there is undoubtedly a fine line where adding too many assets to a portfolio will not reduce risk but dull returns.

What Happens When You Over-Diversify Your Portfolio?

Below are a few consequences of over-diversifying your portfolio:

Diluted Returns

Over-diversifying your investments can spread your gains too thin. While it lowers risk, even big wins in a single holding won’t significantly boost your portfolio’s overall return because each investment makes up a small slice. It’s like adding too much water to juice – the flavour (returns) gets weaker.

Increased Complexity

A highly diversified portfolio would be complex and time-consuming to manage. It would be challenging to keep an eye on the many investments, understand the said portfolio performance, and rebalance them constantly. This could be made difficult by making poor investment decisions based on less detailed knowledge about all the assets.

Higher Costs

Every time you invest, you incur transaction costs. Over-diversification can quickly bring in more transactions, and higher total expenses will eventually affect your returns. 

Practical Tips to Avoid Over-Diversification

Take a look at these practical tips to avoid diversification:

Set Clear Investment Goals

Before making any investment, define your financial goals clearly. Understand your risk tolerance, time horizon, and expected returns. Clear goals will guide your investment decisions and help avoid unnecessary diversification.

Limit the Number of Holdings

Maintain a portfolio with 15-20 high-quality assets. This number is manageable and allows for effective diversification without overwhelming you. If you find an investment opportunity that seems too good to pass, consider selling a less promising asset to keep the total number of holdings within your limit.

Research and Due Diligence

Conduct thorough research before adding any asset to your portfolio. Understand the investment’s fundamentals, risks, and potential returns. Quality research ensures that each asset in your portfolio adds real value and aligns with your investment strategy.

Investment Decisions: Balancing Risk and Reward

Every investor aims to maximise returns while minimising risks. Over-diversification can somewhat reduce risks, but it also caps your rewards. 

Risk Management

Diversification is essential for managing risk in your portfolio. However, there’s a point of diminishing returns.  Consider the marginal benefit of each new investment. If adding an asset won’t significantly reduce your overall risk, the effort of managing it might outweigh the potential gain.

Focus on Core Competencies

Invest in what you know. Your expertise in certain sectors or asset classes can give you an edge in making informed investment decisions. Concentrate on areas where you have the knowledge and avoid over-diversifying into unfamiliar territories just for the sake of diversification.

Seek Professional Advice

Sometimes, the guidance of a financial advisor can be valuable. Professional advice can help you navigate the complexities of portfolio management, understand limitation of diversification, and make informed decisions. A financial advisor can provide a tailored strategy that aligns with your investment goals and risk tolerance.

Conclusion

While diversification is critical to a robust investment strategy, but over-diversification can undermine your portfolio’s potential. Understanding and finding the optimal balance between diversification and over diversification is key to successful investing. Focus on high-quality assets, asset allocation, and regular portfolio reviews to achieve your financial goals.

FAQs

What are the signs of an overly diverse portfolio?

The sign of overly diversified portfolio are minimal individual investment returns, high transaction costs, and difficulty managing and tracking all investments.

How does over-diversification impair portfolio monitoring?

Over-diversification complicates portfolio monitoring since it becomes increasingly difficult to keep up with the performance and risks of all assets. This means there might be instances where one misses the opportunities to rebalance or respond to effectively market changes.

Is it best to be broadly diversified within a single asset class or across multiple courses?

Generally, more can be achieved through diversification across asset classes, as it aids in distributing the risks across different market sectors. Diversifying your investments in only a single asset class can be extremely risky if the said asset class is equity and can affect negatively your future potential return.