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Why Too Much Diversity Can Be Dangerous

Why Too Much Diversity Can Be Dangerous

Too much of a good thing can become a bad thing, and that's true for even time-tested investing tenets like diversifying investments.

Any financial advisor worth their fee will no doubt tell you that you don't want to count on one type of "ship" to sail you safely into your retirement years. But by the same token, a vast fleet of investments could mean failure too.

Like with everything, moderation, balance is key. Here's how being too diversified can do you in.

"A portfolio can be too diverse. Spreading wealth across too many different holdings, whether they are asset classes, industry sectors or geographic markets, can underperform benchmarks and actually add risk," says Howard Hook, a financial advisor and CPA with EKS Associates.

A portfolio can be too diverse. Spreading wealth across too many different holdings, whether they are asset classes, industry sectors or geographic markets, can underperform benchmarks and actually add risk

He offers the example of owning four or five large cap equity mutual funds. "There may be an investment or two that differs amongst the various large cap funds, but the incremental benefit is so small, compared to the potential cost of those additional funds." The bottom line – those added benefits may not exceed the cost.

Keep your portfolio simple

Diversification, if done properly, can be a bit complicated and takes more skill than meets the eye to not be overly diversified, says Melody Juge, founder and managing director of Life Income Management. "I often see people who have 10-20 funds from various mutual fund companies in their portfolios, but they have no idea what exactly is 'in' the fund. All they know is the label of the fund: growth, equity-income, balanced, etc. By making random selections you could easily be unwittingly be top heavy in more than one stock or bond," she says.

How much can you really manage?

Most people don't more things to do than hours of the day to do them. The reality is, you probably don't have an enormous amount of time to devote to your investments. You can't set it and forget it. You do have the mind the store. Truth is, owning too many investments is a lot of work. "It's important to know what is going on with the investments you make and owning too many makes it more difficult to spot a particular area of concern in one of them," says Hook.

Another danger with too many investments, is that you might be too nonchalant about your investments. You rest on the fact that you have many working on your behalf that you may be too casual about one or two that should be tossed from your portfolio, until it's too late.

Be realistic. Build a portfolio that is manageable.

You can spread risk too far

The reason for diversification follows the same logic as don't put all your eggs in one basked. "It's possible to do so, and to score an enormous win and indeed some people do so. Most of us, however, don't have the discipline or patience. We all wish we'd bough 1,000 shares of Microsoft in 1985 and never sold it (or maybe sold some of it in 1990, but hindsight is not a plan, so we diversify into many different companies to spread out risk," explains John Brandy, a wealth manager with Columbia River Advisors.

The problem with diversifying too much, he explains, is that you spread the risk so far that you minimize terribly the opportunity to profit from good analysis of a company. Instead, you're just gambling again. "If you you invest $10 into each of 500 companies, you're not likely to end up any better off than if you put $5,000 into an S&P index mutual fund. In fact, you're probably going to end up worse off after the trading fees," says Brandy.

Think Goldilocks

So how to strike a balance – to have diversity, but not too much? "First you can use a tactical management system where you monitor the investments you are in and establish criteria that tell you when to 'pull the plug' and exit that investment, moving the money to other areas that are still performing well, or even going into cash if necessary," says David Shucavage, president Carolina Estate Partners.

That might work for the more sophisticated investors, or those with a lot of time to manage investments, but for less ideal for others.

The best way to strike a balance is to use mutual funds, rather than individual stocks and or bonds, says Hook. He says mutual funds give you automatic diversification in the number of holdings for that particular asset class. "It's probably best to stop there however. Further diversifying one level down within an asset class means adding an additional one, maybe two tops funds that differ slightly than the first in the types of companies," he says.

The best way to see how each of the funds fits with the others, is to research the funds and their holdings. Websites such as Morningstar.com or Yahoo! Finance are good places to start, says Hook.

Warren Buffett has said that, "diversification is protection against ignorance." However, going overboard is unwise too.

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Shorebreak   |     |   Comment #1
Advice from the index-fund mastermind John Bogle...

Simplicity is key

Q: What is the most important piece of advice you have for someone who is new to investing?
A: Rely on simplicity; own American or global business in broadly diversified, low-cost funds.

Anonymous   |     |   Comment #2
Or you can get an ETF closed end fund and you are automatically invested in over 500 companies globally. Problem solved.
Anonymous   |     |   Comment #3
I bought a stock one time. Scott Tissue.  Right after I bought it, it hit a new bottom and thousands were wiped clean.  I learned my lesson then to not invest in stock or mutual funds with any money than I can afford to lose.
DCGuy   |     |   Comment #4
To #3 -  When you say Scott Tissue that hit a new bottom and being wiped clean, I come up with a vision of toilet activity.

While I do agree about not investing in something that you cannot afford to lose, my parents did not invest one cent in the market and when they retired, their retirement account balances decreased at a faster pace as the interest rates on CDs plummeted over the past seven years.
Anonymous   |     |   Comment #5
To #4,  this is #3 again,

To determine that you can afford to retire, use calculations with low 2 - 3% returns on CDS to assure you have enough income for cover future expenses (be sure you do not overestimate medical for your expenses).   Add some cushion and then the amount left over (the amount that you can afford to lose) diversify it into the stock market for potential higher gains.  If your calculations do not meet these requirements, then do not retire but keep working until you are financially able.  Do not make a mistake and determine that the higher projected rates that you possibly might make in the stock market.

After you have retired, if you only had two choices for two different possible situations that happened in past historical financial events, which side of the fence would you want to be on? 

The side that lost half or more of what they invested in the stock market with a little bit of toilet paper left in their back pocket or the side that got reduced interest rates on their CDS, but none of their principal was taken away?
Anonymous   |     |   Comment #6
What I meant to say do not "underestimate" your medical expenses when figuring your retirement.  I am telling you this because that was a mistake I made.  My insurance premiums have jumped through the roof since I retired. 
Anonymous   |     |   Comment #7
Two people: 15K/year medical/dental premium.
One year expense: 60K dental implants.
Plan to retire or retire your plan.