Experts agree that diversification is the best way to protect the overall value of your portfolio. By including a mix of investment types that behave differently under specific economic conditions, you can reduce the risk of poor-performing investments.
For example, imagine you invest all your money buying stock in a hot new company and that stock suddenly drops by 40% or 50%. Your portfolio takes the full hit of that loss. However, if you'd spread that money across 20 different stocks, sectors, or asset types, the hit to your portfolio would be minimized because you had plenty of other investments to pick up the slack.
In short, diversification is essential, but there is such a thing as being too diversified.
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The anxious investor
Let's say you're working hard to plan for the future, and frankly, investing makes you nervous. Your anxiety frequently produces thoughts like "What if there's a recession and I can never regain what I've lost?"
There are many different types of investors, and naturally, some are more averse to risk than others. There's nothing wrong with that. It only becomes a problem when you take steps that can ultimately cost you money, like overdiversifying your portfolio with the mistaken belief that it can shield you from losses.
Finding balance
So, if diversification is good but overdiversification is not, how can you tell the difference?
A balanced portfolio is a lot like the perfect bowl of soup. There may be many ingredients, but they work together. Each ingredient plays a specific role. In terms of a portfolio, here's how diversifying can help protect your investment by behaving differently under particular conditions:
- Stocks: High potential for growth but volatile.
- Bonds: Stable, lower-risk assets. Suitable for preserving capital and for balancing the volatility of stocks.
- Gold or commodities: Tend to move in the opposite direction of stocks during turbulent markets. In other words, when stocks are down, gold or commodities are often up.
- Real Estate Investment Trusts (REITs): Offer the opportunity to profit from property markets without having to own physical property.
- International assets: Help protect your portfolio when domestic markets are down.
Your portfolio may look quite different, and that's OK. The point is to choose investments that tend to react differently to market conditions, so when one is down, the others can keep your portfolio afloat.
How overdiversifying can water down the soup
When you overdiversify, you run the risk of:
- Lowering your overall gains: High-performing assets may not contribute significantly to your portfolio's overall return if a large number of low-performing investments dilute their weight.
- Mental fatigue: The energy required to manage a multitude of investments exceeds what's needed to manage fewer. The more complex your portfolio, the more likely you are to hit a wall of mental fatigue and to make less strategic choices.
- Lost opportunities: As your money is spread thin, you may miss out on opportunities to invest in higher-quality assets.
- Higher transaction costs: You may incur more transaction fees and management costs simply due to the number of assets included in your portfolio.
How you can tell you're overdiversified
Here are key signs that your portfolio needs rebalancing:
- You own too many similar investments.
- You can't always keep track of your holdings.
- Your portfolio's performance mirrors (or underperforms) the market.
- You find it difficult to rebalance because you hold so many small positions.
- You can't recall why you invested in several assets.
- You're paying high fees that eat into profits.
If you're diversifying your portfolio, your decision to do so is spot-on. However, if you're overdiversifying, it can end up costing you money without mitigating risks.
