Assuming you invest in individual stocks and/or mutual funds, what is one of the first questions you should ask if you want higher investment returns? The answer is, “Do I own too many investments?” This is an essential question because of the potential hidden costs of owning too many investments, also known as over-diversification.
While many investors focus on what they can see, such as taxes, fees, gains, and losses, what they can’t see may matter even more. For example, you will most likely never see a line item on your monthly brokerage statement that says, “Your total investment return was reduced by X percentage this month due to over-diversification.” In theory, the cost of over-diversification could far exceed other potential costs in your portfolio. Just because you can’t see something doesn’t mean it’s not important. Here are four potential hidden costs of over-diversification that can result in lower investment returns for your portfolio:
- Opportunity costs: Over-diversification can prevent you from focusing your money on higher-quality investments with greater growth prospects. In other words, if your money is spread too thinly across too many different investments, you may not have enough invested in any particular holding to see significant gains. The net effect of this over-diversification can be lower overall investment returns;
- Higher potential taxes: Owning too many different investments can make managing your potential tax liabilities more challenging, especially if you have multiple accounts. This is important to consider because taxes reduce your investment returns;
- Reduced ability to make informed investment decisions: Over-diversification can make it more difficult to manage a portfolio, e.g., keeping track of all the investments you own. This can result in not making timely and informed decisions about which investments to buy, sell or hold; and
- Increased susceptibility to market fluctuations: If your portfolio is over-diversified within a given market, such as the U.S. stock market, there is a good chance your portfolio is highly correlated with the overall market. This means that if the market drops 20%, you should most likely expect your stock portfolio to go down at least this amount. While such an outcome is also possible with less diversified portfolios, any expectations of an over-diversified portfolio insulating the investor from sharp market declines can be unrealistic.
While diversification is a critical tool for reducing the risk of loss in your portfolio, it can also be, as the old saying goes, “Too much of a good thing.” As a result, it is essential to strike a balance between diversification and a concentration of investments appropriate for your investment goals and comfort level with risk.
Unfortunately, there is no official definition of an over-diversified portfolio, and opinions will vary depending on whom you talk to. Despite the challenges of determining if an investment portfolio is over-diversified, there are some top indicators we look for when reviewing an investment portfolio for this potential problem.
If you are trying to answer the question, “Do I own too many investments?” we can help you answer this question with a simple phone call. Just call us at 713-850-8900, and we will be happy to respond to your questions.
About The Goff Financial Group: As a fully independent Registered Investment Advisor, the Goff Financial Group is not owned or controlled by any bank, brokerage firm, mutual fund company or any other company. The company does not receive any fees or commissions from any financial products and works solely for its clients on a fee-only basis. Disclaimer: This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
