Can You Over Diversify Your Investment Portfolio?

As the saying goes, you can have too much of a good thing. This principle applies to most things in life including portfolio diversification.

When applied efficiently, portfolio diversification is a proven method for reducing overall portfolio risk exposure. However, it is possible to over-diversify investment portfolios.

In his book, One Up on Wall Street, Peter Lynch coined the term “diworsification”, which has evolved as a label for over-diversifying portfolios where too much diversification actually worsens portfolio performance.

What is Over-Diversification

Over-Diversification occurs when each additional investment included in a portfolio lowers the expected total return by a greater amount than the associated reduction in the total risk profile of the portfolio.

Academic studies have shown that optimal diversification is achieved with 20 to 30 portfolio holdings. As the number of holdings is increased there is no added benefit of risk reduction and potential returns may actually decrease.

Effects of Over-Diversification

• Over-diversification reduces a portfolio’s potential returns without a corresponding reduction in its risk profile.
• Adding new holdings for the purpose of diversification decreases the allocations to existing holdings that may have been purchased for their higher return potential.
• Having excessive portfolio holdings increases the time required for due diligence and monitoring. This may lead to less focus on each individual security and missing optimal buying and selling indicators.
• Increased holdings contribute to higher transaction costs, operating expenses, and turnover.
• Duplication of similar securities may actually compound risk while diluting the performance of portfolio out-performers.
• As more holdings are added the portfolio may unintentionally become “index hugging” as it becomes more like its benchmark index.

Diversification is a proven method of reducing an investment portfolio’s risk profile. However, to reduce downside risk, some potential upside performance is sacrificed. A level of diversification will be reached where it becomes “over-diversification” and the benefits no longer justify the loss of returns.

Diversify Your Investment Portfolio with Bloom

Since 1985, Bloom Investment Counsel, Inc. has been providing actively managed diversified portfolios for our clients. Our investment portfolios are typically comprised of 25-30 positions in dividend-paying stocks with individual weightings aimed to not be less than 1.5% of the overall portfolio. Thorough understanding through research and analysis in addition to meetings with management teams empowers our conviction in decision-making.

At Bloom, we focus on generating superior long-term risk-adjusted returns and are very patient in our investment approach. We continuously monitor our investments on both a macro and micro basis and make changes accordingly. To learn more about our customized diversified dividend-paying investment portfolios give us a call at 416-861-9941 or email us at info@bloominvestmentcounsel.com.

This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.