You may have heard that diversification is the golden rule of investing. And while diversification is an important part of risk management, you can have too much of a good thing.
Having an overdiversified portfolio can distract you from the overall picture and can ease you into thinking that quantity of diversification is more important than quality of diversification. An overdiversified portfolio is also complicated to analyze and the impacts of each investment on the portfolio as a whole becomes less clear, meaning it may be difficult to ensure your portfolio mix aligns with your risk tolerance. When you have too many factors influencing the performance of your portfolio, you may not be able to determine what is driving your return, which makes it difficult to make informed decisions about your future investments.
4 Signs Your Portfolio Is Overdiversified
How do you know how much diversification is too much? Here are four signs to look for.
1. You Have Multiple Mutual Funds in the Same Investment Style Category
Each mutual fund is classified by an investment style, such as “small cap growth” and “large cap value,” that group together mutual funds with similar assets, risk and investment strategies. Investing in more than one mutual fund in the same category increases how much you pay for your portfolio to be managed without giving you the benefits of diversification.
2. The Number of Individual Stocks You Have Creates a Management Burden
When you have too many individual stocks, the expense of managing those stocks and the burden of the required due diligence for taxes is more costly than the additional stocks are worth.
3. You Rely Heavily on Multimanager Investments
Multimanager investments products (such as funds of funds or feeder funds) can add instant diversification to your portfolio. However, over-use of this strategy means that you have a financial advisor who is monitoring an investment manager who is monitoring more investment managers.
4. You Own Privately Held “Non-traded” Investments That Are the Same as Your Publicly Traded Investments
While privately held investments are advertised as more diverse and less risky, the valuation methods used are complex. Be sure to clarify how its risk/reward is different from the publicly traded investment you already own — because in actuality the two may not be that different.
In general, when you add complexity to your portfolio without decreasing risk or increasing your returns, you are overdiversified. If you feel your portfolio is over-diversified, contact a Farm Bureau financial advisor to start getting back on track.
Top four signs of diversification. Investopedia.
A portfolio that’s too diversified can end up costing you. The Wall Street Journal.