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Is over-diversification a problem?

Larissa Fernand  |  09 Apr 2015Text size  Decrease  Increase  |  

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Larissa Fernand is the editor of the Morningstar India website.


In the overall scheme of investor problems, over-diversification isn't the worst sin. Having too many holdings won't wreak the same havoc that under-saving will, or performance-chasing.

Nevertheless, at Morningstar we believe there's a practical risk to being too diversified. When you own too many stocks and managed funds, it becomes nearly impossible to get a good knowledgeable grasp on each holding.

When you lose your focus, you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things.

Christine Benz, Morningstar's director of personal finance who is based in Chicago, says that for every single portfolio she receives that is whippet-thin -- without an excess stock, fund or exchange-traded fund (ETF) to spare -- she comes across 10 more that have 50, 60 or even 100 individual holdings.

She refers to over-diversification as portfolio sprawl and believes that it can add to investors' oversight challenges.

It can simply be difficult to keep track of the fundamentals of so many holdings, especially if those holdings include individual stocks along with actively managed funds of various categories. The investor with too many holdings may have trouble figuring out asset allocations or knowing when or how to rebalance.

No matter how logical an investor you believe you are, you could get carried away and buy on whims or fall for the latest market craze.

Some investors pick up certain funds or stocks that have a "cult status," so to speak. Splintering your portfolio into too many different funds and can dilute the impact of any one investment. An over-diversified portfolio can stunt returns and amplify risk.

By blindly assuming more is safer, over-diversification gives a false sense of security.


Cut off the excess

You need to diversify smartly. Having a glut of funds is not smart diversification. For instance, a portfolio with three mid and small-cap funds, three sector funds, an index fund and three large-cap funds is not a well-diversified one just because it has 10 funds.

Does the index fund track a large-cap index such as the MSCI Australian Shares Large Cap index or the S&P/ASX 50 index? That would translate into a number of large-cap funds with a focus on the dominant sectors -- financials and resources.

Are two sector funds necessary when the other funds are diversified equity funds investing in all the relevant sectors? Does one need an exposure to three different mid-cap funds or would two just suffice -- one with a value blend and the other with a growth tilt?

Does the overall portfolio have sufficient debt exposure since none of the funds are balanced or debt-oriented? Such questions would need to be answered when viewing the portfolio as a whole and preferably with the help of a financial adviser.