The Dangers of Excessive Diversification

The Dangers of Excessive Diversification explained by professional Forex trading experts the “ForexSQ” FX trading team.

The Dangers of Excessive Diversification

The virtues of diversification have been drilled into the heads of financial professionals and novices for the past fifty years but excessive diversification is rarely discussed. Perhaps this is understandable.

In some cases, investors have been told it doesn’t particularly matter what they own, only they own the right asset classes. To any investor with common sense, this is pure foolishness. It ultimately is the individual positions that matter and despite what some famed economists would have you believe, the aggregate quality of a given portfolio cannot substantially exceed the underlying individual quality of the specific components – if you’re sitting on a pile of junk, adding more junk isn’t going to keep you meaningfully safer.

To say otherwise is the same sort of nonsense that led to baskets of collateralized debt obligations made up of sub-par assets receiving an investment grade rating! If history has been any guide, absent some sort of industry or sector paradigm shift, you’d be far better off owning a mediocre real estate investment than shares of American Airlines over the next quarter-century even though common stock, as a class, typically leads to higher compound annual growth rates over longer periods of time.

Please don’t misunderstand me. Diversification is a wonderful thing and the concept of “don’t put all your eggs in one basket” is a wise one for those who are unable or unwilling to evaluate the attractiveness of investment opportunities. The trick is not to take it too far; to pay attention to the portfolio weightings intelligently while measuring trade-offs.

How Much Diversification Is Too Much In Your Equity Portfolio?

There are several dangers in acquiring more stocks, bonds, real estate properties, or other assets than can be reasonably monitored.

How much diversification is too much? Generally speaking, the average investor should probably hold no more than twenty or thirty well-chosen, defensively selectedcommon stocks, which corresponds to an individual component weight of 3.33% to 5.00%. Almost certainly, he or she should own less than 100 stocks.

To learn more about this topic and delve into the mathematics, read How Much Diversification Is Enough?.

Excessive diversification beyond this point, especially for non-professionals who lack the resources and time necessary to regularly monitor the operating performances of the businesses by reading the annual report and 10-K filing, presents the following problems (note that this limit does not apply to those engaged in risk arbitrage or the purchase of sub-working capital equities):

Excessive Diversification Might Cause You To Lower Your Investment Standards– When you can add anything and everything to your portfolio, you are much more likely to loosen your well-established, conservative standards, thereby accepting greater company or price risk. This happens, in part, because each position represents a smaller capital commitment. Billionaire investor Warren Buffett recommended a mental trick to get around this. He told investors to imagine they had a punch card with only twenty slots on it. Each time they made an investment, they had to punch one of those slots. Once they ran out of slots, they could never buy another investment for the rest of their life. Buffett argued that this selectivity would cause a lot more intelligent behavior because people would actually learn about the things into which they are putting their money to work, leading to less risk-taking and better decisions.

Excessive Diversification Might Cause You To Neglect What You Do Own – Unless you’re employing a ghost ship approach in which passivity is taken to extreme measures, you most likely won’t have time to pay attention to each investment; to notice real changes in the underlying operating business such as a significant deteriorations in margins or competitive position until it has already destroyed intrinsic value.
Excessive Diversification Might Cause You to Dilute Your Best Ideas As Each Position Exerts a Smaller Influence on the Portfolio – When you become excessively diversified, your capital gets spread so thinly that even an excellent investment has only a marginal influence on the total value of the portfolio. For example, during the banking crisis, it was quite clear that a handful of institutions were many, many times stronger than their competitors; rock solid balance sheets, strong underwriting standards, minimal losses. These firms were battered down alongside the poorly run, bordering-on-insolvent banks. Why would a reasonable person want to buy all of the banks equally or with some other across-the-board accumulation strategy? Why would they want to put their hard-earned money into their fourth, or seventeenth best idea when they could still add to their first, best idea without taking on too much risk?

Excessive Diversification Might Substantially Increase Your Costs – Although this isn’t really a concern once investors surpass, say, the $500,000 in investable asset line when trading costs and other expenses become a much smaller percentage of the overall portfolio, even “cheap” commissions of $10 or less per trade can add up if you’re dealing with dozens and dozens of individual positions.

There Are Ways to Achieve Ample Diversification Without a Lot of Cost or Hassle

If you want to hold a diversified portfolio without the hassle or frictional costs of selecting individual investments, you might want to consider HOLDRs, Diamonds, Spiders, or other basket investments or index funds. Many of these securities trade just like stocks on the open market and are a type of exchange traded fund, or ETF. The difference is, when you purchase a HOLDR, for example, you are beneficially buying shares in dozens of companies in a particular industry or sector. Investors that purchase diamonds are literally purchasing a fraction of each of the 30 stocks that make up the Dow Jones Industrial Average so with one trade, you’re buying the Dow Jones. These may be useful tools in your quest to build a diversified portfolio instantly while significantly reducing transaction costs and brokerage fees.

A Note on Portfolio Rebalancing

Generally speaking, you should never sell a stock merely because it has increased in price. In the world of diversification, the concept of so-called “rebalancing” has received far too much attention. If the fundamentals of the business (margins, growth, competitive position, management, etc.) have not changed and the price still appears to be reasonable, it is foolish to sell the holding for another business that does not possess the same attractive qualities even if it has come to represent a significant portion of the overall value of your portfolio. Famed money manager Peter Lynch called this practice, “cutting the flowers and watering the weeds”. Billionaire investor Warren Buffett tells us that, “the most foolish maxim on Wall Street is, “you can never go broke taking a profit’”.

Indeed, an investor that early on purchased shares of Microsoft or Coca-Cola as part of a diversified portfolio would have been made millionaires many times over if they had merely left these excellent businesses alone. There is only one primary rule of investing: In the long run, business fundamentals will determine the success of your holding if the security was purchased at a reasonable price.

The only exception to this rule I consider justifiable is when you decide you are not willing to risk a certain amount of capital. No matter how great a business might turn out to be, you might not be comfortable with more than 10%, 20%, or 50% of your net worth in it. In cases such as this, risk reduction is more important than absolute return.