Ask any Wall Street analyst for advice on how to minimize risk and chances are they will tell you to diversify your portfolio. Diversification has for decades been touted as the No. 1 way to insulate oneself from volatility and unexpected downturns. Certainly, most of us would agree that putting your life’s savings into a single investment is unwise, so there is something to the idea. But what happens when this approach is taken too far? Can one be excessively diversified? The answer is yes, and being overdiversified can seriously damage your returns.
Too many irons in the fire
What is the problem with overdiversification exactly? After all, doesn’t owning a lot of different stocks protect you from the downside risk of any one company going under? While that is true, there is another side to that particular coin. The more positions you have, the more time you are going to have to spend researching each individual business.
If you are a serious investor who really thinks before committing their capital, this is likely going to add up to an unreasonable number of hours. How many exactly? A 2002 paper titled "How much diversification is enough?" estimates the optimal number of stocks in a properly diversified portfolio to exceed 300! At that point, any benefits you may have gained from diversifying would surely have been wiped out by the risk of taking on so many unknown investments.
The problem of having your attention divided amongst so many different stocks is further compounded when one considers that you are likely going to have to invest in a number of different industries. There’s no point buying 100 different biotech firms in the interest of diversification, only to see your portfolio decline when the sector as a whole suffers some decline, perhaps as a result of regulations on drug pricing. So victims of overdiversification end up being unable to focus on any one investment, putting their entire portfolio at greater risk than if they had just stuck with 10 or 20 businesses.
Moreover, by having such a large number of stocks in your portfolio, you are decreasing the extent to which any one security can outperform. Sure, the risk of all those businesses failing for random reasons is quite low, but you are still exposed to the systemic risk that your chosen industry, or the entire market, goes under. So in other words, overdiversification kills your chances of outperforming the market, but does not protect you from potential downside moves.
Disclosure: The author owns no stocks mentioned.
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