Can an Investment Portfolio be too Diversified?

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“Diversification is good.” This is usually the first pearl of wisdom bestowed upon new investors who ask. After all, it has been known for a long time that not having all of one’s eggs in the same basket is just plain prudent. However, over diversification, although typically less costly than a lack of diversification at the extremes, can set investors up for frustration and unfulfilled objectives.

What is Over Diversification?

A benefit of diversification is derived from the addition of an asset to a portfolio in such a proportion that it decreases the portfolio’s variance (risk) without decreasing the expected rate of return. Conversely, over diversification results from the addition of an asset to an already diversified portfolio in such a proportion that it does not reduce the overall risk of the portfolio, and does not increase the expected rate of return.

Essentially, over diversification results from the inclusion of investments within a portfolio that are, at best, unnecessary to accomplish the desired risk and return profile, and, at worst, make a portfolio riskier without increasing the expected rate of return.

How is Proper Diversification Determined?

Unfortunately, the diversification benefits of selected asset allocation weightings within an investment portfolio can only be truly assessed in hindsight. Questions have to be answered: Did the portfolio perform on a risk and return basis the as expected? What was the proportional contribution of each asset to the overall return of the portfolio? What was the proportional contribution of each asset to the overall risk of the portfolio?

Establishing a portfolio thought to be adequately diversified in advance requires data on how assets available for potential inclusion into a portfolio have behaved in the past. From this information, it is possible to determine, on an historical basis, how a given asset reacted to various economic circumstances.

By comparing this information as it pertains to each asset to each of the other potential investments, an idea of how various assets would have performed in conjunction can be formed. From there, the historical data can begin to be molded to an investment manager’s thoughts about the future in the context of a portfolio’s risk tolerances and return objectives.

Even for the best of the best professionals, achieving all of the expected benefits of diversification from a particular asset allocation is difficult and unlikely. There are simply too many variables.

So, even on a professional level, time could reveal that a portfolio was over diversified. That is, some assets could have had their weightings reduced or been eliminated entirely and the portfolio would have experienced higher returns and/or less variance. However, this is true of investing in general when viewed in hindsight. The ex-ante process of trying to reap benefits from diversification arguably has its merits nonetheless.

But this is when professionals are thoughtfully trying to establish an appropriately diversified portfolio based upon all the information available to them. In this this case, the over diversification that might result could be largely unavoidable.

Thankfully, some more run-of-the-mill varieties of over diversification and unnecessary diversification can be more easily addressed in advance.

Simple Over Diversification

Two common sources of over and unnecessary diversification result from naïve diversification and shotgun portfolios.

Naïve diversification is actually a technical term that specifically refers to investors equally allocating their assets to each of the available investment options within their employer sponsored retirement plan. This occurs with good intentions, because everyone knows that diversification is good. Unfortunately, depending on the options available to a plan participant, equal allocation among available investments could result in a portfolio that is heavy on investments but low in the theoretical benefits of diversification.

Retirement plan administrators have become increasingly aware of this phenomenon, and many have begun to choose their investment options with this in mind. In fact, the exploding popularity of target date funds could probably be attributed to attempts at correct issues associated with naïve diversification. Although, target date funds come with their own set of baggage, they might also help in the fight against the next source of simple over diversification, shotgun portfolios.

Shotgun investment portfolios are akin to naïve diversification, but created outside of a retirement plan. Similar to naïve diversification, a shotgun investment portfolio is usually the result of a good intentioned investor trying to become diversified, but not being sure how to accomplish it, and buying a little bit of everything to cover all the bases.

The real issues with the typical shotgun portfolio is a lack of efficiency, and the illusion of diversification.

New investments in a shotgun portfolio are purchased simply because they are thought to be different than other investments in the portfolio, and not because of their underlying risk and return characteristics. As a result, these portfolios can range from overly exposed to certain risks, to allocation weightings so evenly exposed to inversely correlated returns that the portfolio tears itself apart at the seams without producing returns commensurate with the risks taken.

These effects illustrate a common illusion of diversification. Owning many investments does not necessarily mean that all risks have been mitigated, or that a portfolio is being appropriately rewarded for the risks it takes.

Can Over Diversification Be Avoided?

Even among thoughtfully diversified portfolios, it is nearly impossible to fully avoid over diversification across time without risking under diversification. With regard to over and unnecessary diversification resulting from misdirected good intentions and a lack of understanding, there are a few relatively easy fixes that might increase the potential for efficiently benefiting from diversification.

As mentioned previously, target date funds were largely created to help investors easily overcome the common pitfalls associated with random investment selection in the name of diversification. Of course, target date funds do have their own sets of issues. An investor could potentially put out one fire, only to start another. Still, the products are there, and they provide one answer to the problem of over diversification.

There are also many basic software packages now available to investors that will examine the characteristics of the investments within a portfolio and provide recommendations about how to reallocate the portfolio in an effort to more efficiently capture the potential benefits of diversification.

Of course, there is always the option of seeking help from professional investment managers.

Ultimately, over diversification might be difficult to avoid entirely without exposing a portfolio to under diversification. Thoughtfully examining the characteristics of investments prior to inclusion in a portfolio, however, might allow assets to be allocated more efficiently while increasing the potential to benefit from diversification.

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