Signs of over-diversification

diversification! diversification! diversification! Financial advisers like to recommend this portfolio management technique, but are they always looking for your best interests when doing so? If executed properly, diversification is a time-tested method to reduce investment risk. However, too much diversification or “diversification” can be a bad thing.

Originally described in Peter Lynch’s book, One on Wall Street (1989), as a company-specific problem, the term diversification has evolved into a buzzword used to describe inefficient diversification associated with the entire portfolio.

Just like a clumsy corporate group, having too much investment can confuse you, increase your investment costs, increase the number of layers of due diligence required, and result in lower-than-average risk-adjusted returns. Read on to learn why financial advisors may be interested in over-diversification of your investment portfolio, and some signs that your investment portfolio may become diversified.

Key points

  • For portfolio management, diversification is generally regarded as an important factor in reducing investment risks.
  • However, there is a risk of over-diversification, which may cause confusion and result in lower-than-expected risk-adjusted returns.
  • How many stocks or other financial issues are best to include in a portfolio can vary according to the needs of individual investors.
  • Signs of over-diversification include having too many similar mutual funds of the same category, too many multi-management products, including funds of funds, too many individual stocks, and misunderstandings about the risks of privately held non-trading investments.

Why some consultants are over-diversified

Most financial advisors are honest and hardworking professionals who have an obligation to do the best for their clients. However, job security and personal financial income are two factors that may prompt financial advisers to over-diversify their investments.

When providing investment advice for earning a living, the average level can provide more job security than trying to stand out from the crowd. Worrying about losing your account due to unexpected investment results may prompt the advisor to diversify your investment to a mediocre level. In addition, financial innovation makes it relatively easy for financial advisors to diversify your portfolio into many “auto-diversified” investments, such as funds in funds and target date funds.

Assigning portfolio management responsibilities to third-party investment managers only requires consultants to do very little work, and if something goes wrong, it can provide them with an opportunity to blame. Last but not least, the “liquid capital” involved in excessive diversification can generate income. Buying and selling investments with different packages but with similar basic investment risks will hardly diversify your portfolio, but these transactions usually result in higher fees and commissions for the advisor.

Now that you understand the motivation behind the madness, the following four signs indicate that you may undermine investment performance by over-diversifying your investment portfolio:

Have too many similar funds

Some mutual funds with very different names may be very similar in terms of their investment holdings and overall investment strategies. To help investors screen marketing hype, Morningstar has developed mutual fund-style categories such as “big cap value” and “small cap growth.” These categories combine mutual funds with basically similar investment holdings and strategies.

Investing in more than one mutual fund in any style category increases investment costs, increases the required investment due diligence, and generally reduces the diversification rate achieved by holding multiple positions. Cross-referencing Morningstar’s mutual fund style categories with different mutual funds in your portfolio is an easy way to determine if you have too many investments with similar risks.

Be wary of consultants who drive what you might think is over-diversity, because the motivation may be financial.

Excessive use of Multimanager products

Multimanager investment products, such as funds in funds, can be a simple way for small investors to achieve instant diversification. If you are about to retire and have a larger investment portfolio, you’d better diversify your investments among investment managers in a more direct way. When considering multi-manager investment products, you should weigh their diversified advantages against the lack of customization, high cost, and diminishing due diligence.

Is it really beneficial for you to have a financial adviser supervise investment managers, and then supervise other investment managers? It is worth noting that at least half of the funds involved in Bernard Madoff’s notorious investment fraud were obtained indirectly through multi-manager investments (such as funds in funds or branch funds)? Before the fraud occurred, many investors in these funds did not know that their investments with Madoff would be buried in a maze of multi-manager diversification strategies.

Too many personal stocks

Too many individual stock positions can lead to a lot of due diligence, complicated tax situations, and simply imitating the performance of stock indexes, albeit at higher costs. A widely accepted rule of thumb is that it takes about 20 to 30 different companies to fully diversify your stock portfolio. However, there is no clear consensus on this number.

In his book Smart investor (1949) Benjamin Graham suggested that having 10 to 30 different companies would fully diversify the stock portfolio.In contrast, an article in 2004 Financial Analyst Magazine Meir Statman pointed out in an article entitled “Diversity Mystery” entitled “Diversification Mystery”, “According to the rules of mean-variance portfolio theory, the best diversification level today exceeds 300 stocks.”This article updates Statman’s early work in 2002 and 1987 requiring at least 120 stocks and 30 to 40 stocks, respectively-all of which reflect the growth of the stock market over the past few decades.

Regardless of the number of investors’ stocks, a diversified portfolio should invest in companies in different industries and should match the investor’s overall investment philosophy. For example, for an investment manager who claims to add value through a bottom-up stock selection process, it is difficult to justify having 300 great personal stock ideas at a time.

Hold assets you don’t know

Privately held non-publicly traded investment products are usually promoted because of their price stability and diversified advantages relative to publicly traded similar products. Although these “alternative investments” can provide you with diversified investments, their investment risks may be underestimated by the complex and irregular methods used to assess them.

The value of many alternative investments, such as private equity and non-publicly traded real estate, is based on estimated and appraised value rather than daily open market transactions. This “calculated by model” valuation method can artificially smooth investment returns over time. This phenomenon is called “return smoothing.”

In the book, Active Alpha: A portfolio approach for selecting and managing alternative investments (2007), Alan H. Dorsey pointed out, “The problem with smoothing investment performance is its impact on smoothing volatility and may change its correlation with other types of assets.Studies have shown that the effect of return smoothing may underestimate the correlation between the price volatility of investment and other more liquid investments, thereby exaggerating the diversified return of investment.

Don’t be fooled by the way in which complex valuation methods affect diverse statistical indicators (such as price correlation and standard deviation). Non-publicly traded investments may be more risky than it seems and require specialized expertise for analysis. Before buying a non-publicly traded investment, ask the person recommending it to prove how the risk/return is fundamentally different from the publicly traded investment you already own.

Bottom line

Financial innovation has created many “new” investment products with old investment risks, while financial advisors rely on increasingly complex statistics to measure diversification. This makes it very important for you to look for “diversification” in your investment portfolio. Working with your financial advisor to accurately understand what is in your portfolio and why you own it is an integral part of the diversification process. In the end, you will also become a more loyal investor.

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