Investment diversification is often correlated with the adage, “Don’t put all your eggs in one basket.” But how stable is it to carry a bunch of small baskets out to the chicken shed, fill each with an egg or two and then haul them all back to the house? The message here is that there are traps some investors fall into when they diversify. The key is to manage all investments as one portfolio — flexible enough for a bit of jostle and easy enough to manage.
Diversification is the tactic of spreading invested money across a range of different holdings in an effort to avoid losses from one poorly performing investment. However, the point is not to invest in a wide range of securities that may not fit your profile just for the sake of dispersing wealth.
The point of diversifying is to manage risk. When money is spread out among investments, chances are good that, in most market environments, some aspect of the portfolio will continue to grow even when other investments experience a decline.
However, past research has shown that holding too many securities can increase investor cost without delivering better returns or reducing portfolio risk. One study found that the diversification benefit is maximized when an investment holds no more than 20 to 30 different securities. 1
Despite this finding, thousands of mutual funds hold upwards of 100 or more securities. On top of that, many investors hold multiple mutual funds for diversification purposes. Some even add exchange-traded funds (ETFs) — another collection of securities — to the mix, as well as a variety of holdings in their 401(k) plan at work. Therefore, it’s not uncommon for investors to own literally hundreds of securities, with some of the same ones in different funds.
That’s like carrying dozens of baskets of eggs back to the farmhouse. When you consider diversification from this perspective, it is easy to see where investors could be doing more harm than good to their portfolio.
Perils of Over-Diversification: “You should track individual parts of your portfolio to ensure you are not duplicating your investments without any benefits of diversification.” 2