Are You Over-Diversified?

Anyone who has spent much time reading about personal finance knows the value of diversification in a portfolio. If you put all your money into just one or two investments – stocks, bonds, or anything else – you run the risk that something will go wrong and wipe out a big chunk of your nest egg. (Enron, anyone?)

By spreading out your investments, you smooth out returns and lessen the effect that any one holding can have. Modern portfolio theory has shown that a diversified portfolio has a better expected return, for a given level of volatility, than a portfolio that’s concentrated in just a few issues. (To learn more about diversification, read: What is Diversification?)

Automatic Diversification

Mutual funds offer automatic diversification, which is one reason they’ve become so popular. It’s still a good idea to diversify among different funds, though, in order to prevent one fund or asset class from dominating a portfolio. A lot of fund investors learned this lesson the hard way during the technology bubble of the late 1990s, when their tech-heavy portfolios rose to dizzying heights and then fell to earth hard.

But is it possible to be too diversified? Absolutely. After a certain point, adding more funds to your portfolio just creates additional bookkeeping and tax headaches, while doing little or nothing to increase returns or lower risk. When dozens of mutual funds are thrown together, the result tends to be indistinguishable from that of an inexpensive index fund, because any differences among the funds become diversified away. In terms of risk, one study found that a portfolio of four domestic-equity funds already provides most of the diversification benefits of larger portfolios, and that there’s virtually no difference between a portfolio of nine funds and one of 30 funds in terms of volatility.

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However, there’s no exact number of funds beyond which you’re automatically “overdiversified”; a lot depends on your goals and the types of funds you own. Here are some tips for determining whether your portfolio is overly diversified, as well as some ideas for correcting such problems when they do arise.

The Perils of Over-Diversification

As a case study of what can happen when diversification runs amok, consider Chief Justice John Roberts of the United States Supreme Court. As a federal judge, Roberts is required to file financial-disclosure reports each year, and when he was nominated to the Supreme Court last year, those reports attracted a fair amount of scrutiny. Roberts’ most recent disclosure report is from 2003. At the time he filled out the disclosure form, Roberts owned 46 common stocks and 31 mutual funds, along with several money-market funds, bank accounts, and miscellaneous other investments. That’s way more stocks and funds than any one investor really needs, especially given the amount of overlap in Roberts’ portfolio.

What You Can Do

So, what can you do to prevent overdiversification in your own portfolio?

The first thing to do is to make a list of all your investments, organized by asset class. This will make it easier to look at your whole portfolio and decide whether you really need everything that’s there. If you’ve bought funds and stocks through a variety of different channels, as John Roberts appears to have done, there may be more than you realize.

If you own too many funds in one asset class, it’s a good idea to think about trimming that number, as doing so will make your portfolio a lot easier to manage and will also reduce the likelihood that you’ve built a costly, yet indexlike, portfolio. However, be aware of the tax implications if you do decide to streamline your portfolio, especially if it’s in a taxable account. It may be possible to net gains and losses against each other in order to minimize capital gains taxes.

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The important thing is to be aware of your portfolio as a portfolio, and not just a group of mutual funds and stocks collected willy-nilly. Make sure you know the stock market investing basics before attempting any diversification process.

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