How Investors Can Get Hurt From Over-Diversifying Their Portfolios

Any fledgling investor would know that a good investment portfolio consists of a well-diversified set of assets. However, not many are clear about just what level of diversification is sufficient to reduce the risk inherent in their portfolios.

In fact, many believe that more is always better. If you’re one of them, you may be surprised to hear that over-diversification may actually be harmful for your returns.

Read on and discover the true effectiveness of portfolio diversification after researchers performed several studies, as well as how this translates to actual investing.

What Scholars Say About Portfolio Diversification

Historically, both investors and academics believe it’s sufficient to hold only a small number of stocks to be diversified.

For instance, Evans and Archer (1968) calculated that 90% of diversification’s benefit came from just having 16 different stocks, and 95% of this benefit could be captured by 30 stocks.

Similarly, another study by Campbell, Lettau, Malkiel and Xu (2001) argued that an investor only needs about 50 stocks to sufficiently diversify their portfolios. The increase from 15-30 to 50 being attributed to the increased volatility of individual stocks.

However, a study in 2007 by Domian, Louton and Racine claimed that even 100 stocks are not enough to truly create a well-diversified portfolio. So, what gives?

For the average retail investor, the first two studies are more relevant.

They define risk as the volatility of your portfolio’s return. To make your portfolio’s returns stable on a daily basis, all you really need is somewhere between 15 and 30 stocks. Adding any more than that has very little impact on your investment’s volatility.

For instance, once you have 20 stocks in your portfolio, every additional stock that you include up to a total of 50 reduces the volatility of your portfolio by only about 0.04%.

The third study, on the other hand, defines risk as the probability of underperforming. It argues that you would need a lot more than 100 stocks in your portfolio in order to have less than 1% of making less than the risk-free treasury rate.

However, if you delve into the study’s data, you can see that its results are actually not that dissimilar to the first two. For example, once you have 20 stocks in your portfolio, every stock that you add up to 50 reduces the probability of underperforming by only about 0.5%.

The benefit of diversification diminishes very rapidly after you’ve reached 15 to 30 stocks.

Portfolio Diversification in Practice

When you are actually investing your money, it’s very easy to get scared.

If you only have a few investments and one of them declines meaningfully, it’s easy to panic and make a wrong move, such as selling it for a loss. In this sense, diversification to reduce the volatility of your portfolio and probability of lower gains is ideal.

However, you should always only invest in assets you understand. Otherwise, it’s very easy to overpay for your investment.

For example, if you have no idea what a bowl of noodles is supposed to cost, how would you know if your lunch is overpriced? We spend all our lives building an inherent sense of what things are worth and use that as a guide when going through our daily routine.

Investing is almost identical. If you don’t put in the work to really understand what a business does and what its stocks are worth, your “investment” would be equivalent to gambling. After all, there are only two outcomes for both investing and gambling: making a loss or turning a profit.

Portfolio Diversification: Benefits and Costs

This is the main reason why investors should not over-diversify. While each incremental stock after 20 can reduce your risk by about 0.04% or 0.5%, it can burden you with 5-10% more time and effort spent on evaluating its value.

Worse still, increasing your portfolio from 20 to a total of 50 stocks can only reduce your risk by 1% to 16%. Conversely, you’d have to increase your effort by at least 150%.

If you are professional investor whose daily routine involves thoroughly studying companies, you could do this and are most likely paid for it too. Assuming you can’t easily afford this amount of time and effort, however, you would be stretching yourself very thin.

Therefore, when you’re building your investment portfolio, you should do your best to study industries and companies you’re familiar with. The end goal should be to pick 15 to 30 that you really like. Any more than that is likely to dilute the quality of your stocks as well as your conviction in them.

Furthermore, you won’t garner the proportional benefit in terms of de-risking your portfolio. Think about it, wouldn’t you rather buy a few things you know very well at a bargain than stretch yourself thin and own double or triple the amount of items you barely understand and might potentially overpay for?

Related: 3 Investing Tips for Millennials: Start Investing Early, Aggressively and Independently

In Closing

Diversifying your investment portfolio is vital to reduce the amount of risk you take on while boosting your returns as you expose yourself to more asset classes and companies.

For your stock portfolio, research has proven that there is such a thing as over-diversification. Although it doesn’t materially harm your portfolio, especially if you’re able to select all 50-100 stocks well, the amount of time and effort needed to perform the necessary research is too great for most retail investors.

What’s more, with the popularity of ETFs and unit trusts in modern investing, you can easily diversify your portfolio without having to manually pick individual stocks.

If you’re looking to start your investment journey, we’ve got you covered. Check out our round-up of the best online brokerages and trading platforms, where you can conveniently compare the pros and cons of each one.

Read More:

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• How to Assess and Rebalance Your Personal Finance Portfolio
• What You Can Invest In Singapore With S$5,000
• Is Dollar Cost Averaging The Secret to Hassle-Free Investing?
• Hidden Fees To Watch Out For When Choosing An Online Brokerage

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