The Fine Line Between Diversification And Over Diversification

Graphic: Dollars & Sense This article is republished with permission from Dollars & Sense. When we learn about managing our portfolio, we always hear about the importance of diversification. Not many of us have heard of over diversification. Here’s why an over diversified portfolio will do you more harm than good.

Diversification is an important investment strategy that helps investors reduce overall portfolio risk. It does so by allocating investments across various asset classes that have low correlation. The aim of diversification is simple, minimise risk while maximising returns.

The Importance of Diversification

Let’s say your portfolio only contains Food and Beverages (F&B) stocks. It is then made known to the public that all livestock is contaminated due to certain farming practices. The share prices of your F&B stocks will definitely drop in value, and your portfolio is inadvertently affect. If you were well-diversified, you would have protected yourself from such unsystematic risks.

The lower the correlation between investments, the better it is. Unsystematic risks will only affect specific targeted industries and companies. It is important to diversify among different asset classes. They usually perform differently in adverse situations.

While many agree that diversification is no guarantee against market swings and systematic risks, it is still an important strategy to adopt to achieve your goals and objectives. This spreading of wealth to many unrelated financial products helps to reduce volatility and unsystematic risks that may affect your portfolio negatively.

Over Diversification

Many investors have the wrong assumption that more diversification means reduced risk and better performance. Hence, many of them over diversify. They don’t know the negative consequences.

Over-diversification occurs when the diversification does not reduce the risk more than the loss of potential returns. In other words, you lose potential returns with insignificant risk reduction. The point of diversifying is to minimize risk by trading off potential returns. There is no point in diversifying when your returns are lesser, yet your overall risks stays the same.

Chart: BasuNivesh
Perhaps the most common misconception investors have is that risk is proportionately reduced with each different stock or financial product added in a portfolio. This is entirely false. You can only reduce risk to a certain point at which there is no more significant risk reduction or benefits from diversification. The more you diversify, the more potential returns you lose.