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In the investment world, the old saying, "Don't put
all your eggs in one basket," is often used as a reminder of the
importance of diversification. While it is generally accepted that
spreading investment risk around through the use of different types
of investments is a prudent strategy, can an investor be too diversified?
"When it comes to investing, you can have too much of a good thing," says Dan Candura, president of Penny Tree Advisers in
Braintree, Mass.
Financial industry experts agree that overdiversification
can actually thwart your investment goals in the long run, as too
many securities or mutual funds can diminish portfolio performance,
increase costs and create an overwhelming amount of work for advisers
and investors.
The perfect investment recipe
Candura says diversification is like cooking. "You can mix a bunch of ingredients in a pot -- like onions, tomatoes, garlic or meat, but the
end result can turn out very differently depending on the proportions," he says. "Everything may be necessary, but if you put in too much garlic,
it can ruin the dish."
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| Drawbacks of overdiversification: |
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Unforeseen taxes and turnover costs. |
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Mediocre performance due to broad-based exposure. |
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Lack of adequate supervision over each asset class. |
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It's the same for investing as it is in cooking; if you want your ingredients to turn out the way you intend, the key is to
follow a recipe. In investing, asset allocation is the recipe, Candura says.
Asset allocation is key
Creating a proper asset allocation is the first step in determining the right amount of diversification, according to Pat Swanson, Iowa State
University extension specialist. "By having an asset allocation plan, you are able to look at your time horizon, consider risk tolerance, and
have a collection of stocks, bonds and cash that will help you meet your investment goals."
“When it comes to investing, you can have too much of a good thing.”
The way to maximize returns while minimizing risk
is to invest across different sectors, countries, asset classes
or other criteria, says Jim Flinchum, president of Bay Capital Advisors
in Virginia Beach, Va.
Because each of these asset classes reacts differently in various economic environments, having a variety should protect an
investor during up and down markets; at any given time, one or more of your investments should perform well even if the others are down.
How can overdiversification hurt returns?
Unfortunately, many investors overdo diversification because there is a tendency to believe that if more is good, even more is better. "In
investing, this is not the case," Flinchum says, noting that too much diversification can lead to mediocre performance.
Taken to an extreme, diversification can diminish
returns simply because, if you have too many investments, the positive
contribution of one won't be big enough to make a difference. For
example, if a fund or security only makes up 1 percent or 2 percent
of your portfolio, even a significant gain in that investment won't
have a material difference in the overall portfolio.
Using Candura's cooking analogy, overdiversification is the equivalent of not using enough of one spice; you can't taste the
difference at all because it just blends in to the whole.
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