While diversification is a crucial way to spread risk across multiple investments, over-diversification1 occurs when a portfolio owns too many investments. In this instance, there can be some potential “hidden” costs, including reduced return potential without a material reduction in risk.2
If we think of diversification as the cost investors incur to reduce the risk of loss, when do the potential benefits of diversification outweigh the cost to reduce risk? To help answer this question, a study published in the book Modern Portfolio Theory and Investment Analysis looked at how adding additional stocks to a portfolio reduced risk, assuming risk was defined as price volatility.
In this study, a portfolio that consisted of only one stock was expected to fluctuate in price by about 49.2%. $1 million invested in a hypothetical single-stock portfolio could fluctuate in value by approximately $492,000 or between $508,000 and $1.492 million. By increasing the number of holdings from 1 to 20 stocks, the portfolio’s risk level, as measured by price volatility, dropped by roughly 60%, with expected volatility declining to about 20%. This hypothetical portfolio would be expected to fluctuate in value between approximately $800,000 and $1.2 million by this measure.
A surprising finding in the study was that when the number of companies increased beyond 20 stocks, the portfolio’s risk level dropped a meager 0.8% (as measured in terms of price volatility). According to the study, regardless of whether the portfolio consisted of 21 stocks or 1,000 stocks, there was minimal benefit to the investor for incurring the “cost” of diversification by increasing the number of holdings beyond 20 stocks.3
Of course, the study was theoretical, and actual results will vary depending upon a portfolio’s holdings, as the future is always uncertain. How risk is defined in the study is subject to debate, and there is no official definition of a properly diversified portfolio. Other factors impact a portfolio’s diversification level, such as if the portfolio’s stocks are highly correlated with each other in price. Also, a portfolio’s diversification level can be heavily influenced by its total exposure to specific markets and industries.
Despite these limitations, here are some key takeaways from the study:
1.) Diversification is an effective way to reduce risk. However, investors should realize that if they own too many investments, there can be hidden costs without a material reduction in the risk of loss. These costs may include reduced return potential, unnecessary complexity, and “too many eggs in one basket” to properly monitor the risk of loss for each holding.
2.) Regardless of whether you are picking your own investments or paying someone to do that on your behalf, recognize that the potential benefits of individual stock selection decline as the number of holdings grow.
As with most investment-related topics, opinions will vary depending on whom you talk to regarding a proper level of diversification. As a result, answering the over-diversification question can be challenging.
Depending upon your investment holdings, investment return goals, and risk tolerance, your portfolio could be considered under-diversified, diversified, or over-diversified. If you would like help answering the question, “Is my portfolio diversified in a manner consistent with my goals and risk tolerance?” call us at 713-850-8900. We would be happy to assist you.
1 The Dangers of Over-Diversifying Your Portfolio, Investopedia, September 29, 2022
https://www.investopedia.com/investing/dangers-over-diversifying-your-portfolio/
2 Concentrated vs. Diversified Portfolios, Investopedia, January 31, 2022
https://www.investopedia.com/articles/investing/030916/concentrated-vs-diversified-portfolios-comparing-pros-and-cons.asp
3 Here’s Why Over-Diversification in Your Portfolio Tends to Reduce Returns, March 6, 2020
https://www.tomorrowmakers.com/tax-planning/heres-why-over-diversification-your-portfolio-tends-reduce-returns-listicle
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