Diversification Can Be Dangerous to Your Portfolio Returns

Disadvantages of Over Diversification

We often look at the importance of diversification because it is a cornerstone of investment management. The best risk management plan is diversification and I follow strict diversification rules in managing the AAAMP. And, as we have discussed in previous posts, there are many advantages of portfolio diversification; but some lessons can be over learned.

Just because under diversification is dangerous doesn’t mean over diversification is not also harmful. Here are some investment diversification disadvantages:

• Reduces Quality – There are only so many quality companies and even less that are priced at levels you may want to own them at. The more stocks you put into your portfolio the less concentrated your portfolio will be in the best companies.

• Use of Bad Investment Vehicles – Most investors who over diversify use investment vehicles such as actively traded mutual funds or index funds.

• Leads to Indexing – The more stocks you own the more correlated your portfolio will be to market returns. While passive management or indexing might work in bull markets it does not work well in flat or bear markets. Most indices are skewed toward stocks that have already risen and underweight stocks that may have fallen and may be at bargain prices.

• Average Returns – Indexing or over diversification means quality suffers and you own inferior investments along with good investments. This produces mediocre return or worse. In fact, most index investors underperform because they let their emotions cause them to buy high and sell low.

• Lack of Focus on the Long Term – Actively managed mutual funds constantly trade in and out of stocks and have a tendency to focus on short term earnings instead of long term growth over time. Studies show that, on average, actively managed funds underperform market indices.

• Lack of Attention to Your Portfolio – If someone else is managing your portfolio you don’t pay as much attention to it, or you wait until it’s too late (i.e. after your quarterly statement comes).

Yes, diversification is one of the most important concepts in investment portfolio management, but proper diversification is the key. If you keep these disadvantages in mind when building your portfolio you will be more likely to achieve optimal diversification.

Related Reading:

Are Your Investment Returns Suffering From Over Diversification?

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