Are You Overdiversified?

Diversification is a complex investment topic. Everyone in the business is happy to tell you how diversified you should be -- "Mr. Smith, let's spread your assets into 20 different mutual funds. Fees? Don't worry about that." But in reality, owning too many investments is as bad as owning too few, making your returns subpar in any market, increasing your commissions and complicating your taxes, not to mention clouding your peace of mind.

Since the Fool's first book, The Motley Fool Investment Guide, the company line has been "Don't own too many stocks (or funds)." Hold only as many as you can reasonably keep abreast of. Make certain you understand each investment you hold as well as possible. Don't own things that confuse you, or are confusing in general. Complexity is usually a warning sign. Overall, know your strategy.

In practice, this message equates to owning about eight to 15 individual stocks, give or take a few. Chosen well, this relatively small number of holdings can keep you diversified for decades. For investors not buying individual stocks, diversification can be achieved simply by owning a few index funds -- say the S&P 500 index, a mid-cap index, and a smaller-cap index (or, in some cases, a bond index).

In both instances, the objective is to avoid overdiversification while keeping your assets protected against severe downside. As you move through stages of life -- from your salad days to your working prime, to your palm-tree golden years -- your objectives evolve and your investments will need to reflect that, moving away from stocks to more conservative assets. But overall, you'll always want to be diversified -- and not overdiversified.

That's easier said than explained.

To each his or her own
The experience with diversification that I'm best able to share is, for better or worse, my own. For the last several years, I've owned an average of about a dozen stocks and the S&P 500 index in a 401(k). Being three decades away from the idea of retirement, I keep everything in stock and welcome extra risk. Risks can be taken because the portfolio has ballast.

Of the 13 stocks I hold now, five are large-cap giants such as Johnson & Johnson (NYSE:JNJ) and Intel (NASDAQ:INTC), most held in low-fee dividend reinvestment plans. Three other holdings are mid caps that are still growing well, including eBay (NASDAQ:EBAY) and Paychex (NASDAQ:PAYX). The remaining five are more speculative, including the likes of Netflix (NASDAQ:NFLX) and Millennium Pharmaceuticals (NASDAQ:MLNM).

Overall, the portfolio breaks down like this:

This type of diversification is easy to track, what with only 13 positions -- each of which I've followed for quite a while -- and has served me well (outperforming the market) through the downturn and subsequent rise. Typically, I'd like to have another 5% to 10% of the port in short positions (even though I sell options most months that are the equivalent of shorts, but are truly sold for income), so I'm looking for a short or two.

Having about 60% of the portfolio in small- and mid-cap growth stocks may sound risky, but it makes sense given my time frame. Additionally, I didn't plan to have so much invested in mid caps, but like a stepladder, some small caps grew to become mid caps. With luck, they'll become large caps. Meanwhile, I'll keep feeding the portfolio with new small caps when I find them, hoping to repeat this growth process, while weeding out large caps that are slow to grow.

This "rebalancing" program appeals most to me, much more so than trying to keep an artificial level of each type of stock or asset in check. Most forms of rebalancing too often require selling something for artificial reasons. If there's one thing long-term investing should teach you, it's that you want to sell true winners infrequently to never. Rather, I let the portfolio grow and add new positions where needed. If I invest well, that means I'll mostly be adding small caps to replace those that have grown.

Now, naturally, as I advance in years, I'll want more and more large caps and fewer speculative investments. Eventually, I'll start moving some stocks to bonds and cash. But the idea remains the same: Don't overcomplicate the matter; don't own too many stocks; keep your eyes open for new opportunities, but don't always assume that something new to you is better than what you already own.

In a nutshell, keep it as simple as possible. Simple often spells success.

Investor status check
You might be overdiversified (or overactive) if:

• You can't name all your holdings without looking at your portfolio
• You don't know the names of all your mutual funds
• Your returns consistently lag the market averages
• Your annual commissions and mutual fund fees are more than 2.5% of your assets
• Your tax return for capital gains and losses runs a few pages or longer
• Your broker is calling you regularly to move your money around
• It takes you all of breakfast to check all your holdings in the newspaper
• You're always worried about one or another of your positions
• You can't keep current with news and updates from all your stocks and funds

Remember, the simplest pleasures are usually the best pleasures, and with investing, simpler is usually better, too.

Jeff Fischer, a portfolio manager for the Fool from 1996 to 2003, has been a longtime writer for the company. He bought his first stock the day after Black Monday in 1987. His current holdings are available online, subject to the Fool's disclosure policy. Jeff contributed to the new Stocks 2004 .

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