It is a good idea to diversify your portfolio of investments. Doing so reduces the risk of loss by spreading out your investments over several vehicles and several sectors of the stock market. But, can you diversify too much? The answer is, yes. There comes a point where adding more stocks, for example, does not improve your risk profile but makes it harder to keep track of your individual investments. And it takes you away from investments that you understand. If you are a dedicated long term investor, you will routinely review your portfolio and assess intrinsic stock value. While doing this for four or five stocks is reasonable, carrying out this sort of fundamental analysis for more than twenty-five stocks is not. How do you approach this issue? What are the best places to invest your money in order to get a good return and minimize risk? Should you learn how to invest in Mutual Funds or how to invest in index funds and simply let someone else diversify for you?
How Can You Diversify Your Investments?
There are some basics to sound investing that set the stage for diversification. After paying off credit card debts and putting enough money in a bank account to cover expenses for three months, it is time to consider investments. For the vast majority of people, owning their own home is the best investment of their whole life. It is cheaper over the long run to pay off a mortgage than to pay rent and for many people, their largest asset becomes the home they live in. So the first investment is in your home.
Investing and having your taxes deferred until retirement is a huge benefit that you can get from a 401 (K) at work or from an IRA. You may be able to invest these by yourself or may need to pick one of several options offered by work with the 401 (K). Whichever is offered, you should take advantage of the tax-deferred aspect of these opportunities and they should be your second routine investment.
A common and time-tested approach to investing is to treat part of your investments very conservatively so that you do not lose money. Last year we wrote about how to invest without losing any money and focused on bank CDs, US Treasuries, and AAA corporate bonds. As you invest over the years, part of your investment portfolio should go into such safe investments.
The U.S. stock market is generally considered to be the best way to make money over the long term for the vast majority of people. The S&P 500 has appreciated by 10% on the average since its beginning in the 1920s and that includes making up for the 1929 Stock Market Crash and Great Depression. U.S. stocks should be part of your investment diversification routine. And, those stocks should be diversified as well.
Diversifying a Stock Portfolio
Some people simply bypass this issue by investing funds with Fidelity or Vanguard in one of their mutual funds or in an ETF. The difference between an ETF and a mutual fund is that the ETF passively tracks a stock sector or even the entire S&P 500 while a mutual fund is managed and charges you for that service. Investing in stocks this way is easy, passive, and takes very little of your time. But, as we mention in our article about picking the best stocks to invest in, smart investors only invest in companies when they know what the company does to make money and how that business plan will continue to work for the long term future. This approach requires that you limit the number of stocks that you hold to those that you understand and have time to follow. But, even if you have all of the time in the world, can you diversify your investments too much? Yes, you can and here are a couple of opinions on the subject.
How Many Stocks in a Portfolio Are Too Many?
In the book, A Random Walk Down Wall Street, the author makes the point that with an efficient stock market, an investor could randomly purchase enough stocks (ten large-cap stocks or 40 small-cap stocks) to reduce risk and outperform many active investors.
By “diversifying in this way, the investor lets the market take over and generate profits. But, there is a point of diminishing portfolio risk reduction compared to market risk.
If one simply picks large-cap stocks and small-cap stocks at random, one’s portfolio risk is the same as market risk by 25 stocks. Holding more stocks does not provide more diversification benefit but it does increase the work needed to manage the portfolio.
A Market Watch article writes about the exact number of stocks one should own. The point they make is that in order to “beat the market” you need to be invested in stocks that you understand and have time to follow and that does not work very well when you have too many stocks to keep track of.
Is there such a thing as too much diversification? Yes, in fact, there absolutely is, according to Phil Fisher, an influential stock picker whom Warren Buffett BRK.A, -0.54% credits as a major source of inspiration.
“Investors have been so oversold on diversification,” Fisher said many decades ago, “that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.”
Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, agrees, saying that while diversification is critical in mitigating risk, active market participants should be mindful of just how much diversity is ideal.
“Too much of anything can be bad for you and diversification can be taken too far,” he wrote in a post on the Intrinsic Investing blog. “But the level at which ‘too far’ kicks in is surprising to most people.”
In the article, they show the graph from The Random Walk Down Wall Street. Their advice for active investors is to stick with stocks that they know and not “randomly” add new investments in the name of diversification.
Investopedia also warns about the dangers of over-diversifying your portfolio. They start by noting why it is that an investor should diversify.
Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives. There are many studies demonstrating why diversification works – to put it simply by spreading your investments across various sectors or industries with low correlation to each other, you reduce price volatility.
This is because different industries and sectors don’t move up and down at the same time or at the same rate. If you mix things up in your portfolio, you’re less likely to experience major drops, because as some sectors encounter tough times, others may be thriving. This provides for a more consistent overall portfolio performance.
But, they make the point that just buying twenty stocks is not true diversification unless the stocks are chosen to be in different sectors. And, they emphasize that you can diversify your investments too much and crowd out your most promising stocks. They end by quoting Warren Buffett. “Wide diversification is only required when investors do not understand what they are doing.”