Why Diversification Can be Bad for Your Portfolio

Mark Hudson
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Diversification is often considered as one of the prime aspects of investing. It is a practical means of bringing down the exposure to probable downfalls of any particular lone investment. According to a majority of investors, it is prudent to diversify. But this belief often leads a number of investors to a false impression of security and they land up with portfolios that are excessively diversified. Let us discuss four insights which would through light upon proper diversification levels.

1. The advantages of diversification rapidly reduce as you add over 30 holdings.

Risk has two primary components. On the whole, market risks affect stocks at random, and cannot be diversified through a bigger basket of assets. Irrespective of the extent of diversification, everything becomes prone to declines once the economic data sours.

The other kind of risk is known as company-specific risk. This can be done away with by spreading the investment over a range of companies. Holding two stocks in place of a single one considerably diminishes the company-specific risk. However, as per a research report by James Lorie and Lawrence Fisher, if you hold a 32 stock portfolio, the company-specific risk can be eliminated by 95%.

2. Over diversification might lead to average performance.

By having a portfolio containing even 100 stocks, an investor can simply dream of achieving returns that are in line with the broader market. If you add in the costs related to acquiring so many securities, you will come to know that it is not even possible to obtain average performance. This is the main cause of the underperformance of a majority of mutual funds so far as the broader market is concerned.

The advantage of reduced risk is so marginal that it hardly contributes any value. Moreover, the generation of outperformance also becomes impossible. For availing the benefits associated with superior stock choice, a skilled manager must go for positions that are more concentrated.

3. Only adding a superior asset enhances portfolio value.

There has been so much distortion in the message of diversification that a number of investors consider it necessary to include alternative assets within their portfolio. However, one must know that addition of inferior assets just to ensure diversification erodes performance and increases volatility. Surely, there does exist isolated periods when the cost of collectibles or gold has gone beyond the performance of equities as well as fixed income.

Such nonproductive assets do not have intrinsic value and the process is somewhat similar to purchasing something in the hope that a higher price would be paid for it at some point of time in the future. The only way to incorporate value is to rope in an additional constituent within the portfolio that has superior value.

4. If you think of diversifying, execute it.

Apart from incorporating a superior asset, it must also be ensured that the asset does not have a high correlation to the portfolio. In case the portfolio is largely based in the health care domain, incorporating a pharmaceutical company does not have a similar diversification benefit like the addition of something that belongs to another sector.

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