Most advisors with whom we come across are self-proclaimed “Asset Allocators” and in so doing, purport to diversify their clients’ portfolios by spreading their assets across many different classes. Although a worthy exercise, many advisors are told, and unfortunately believe, that when constructing portfolios, more is better and that you never can be too sure.
However, according to the good folks at MotleyFool.com, “It’s possible to have too much diversification. Over-diversification occurs when each incremental investment added to a portfolio lowers the expected return to a greater degree than the associated reduction in the risk profile. In a sense, an investor can hold so many investments that instead of diversifying their portfolio, they’ve engaged in a bit of “diworsification” where their portfolio is worse off because there’s no added benefit to the incremental investments owned above a certain level.”
We agree 100% with MotleyFool.com’s assessment that it is possible to have too much diversification and believe that when advisors take this portfolio construction approach, they are essentially bubble wrapping the bubble wrap, potentially lowering the portfolio’s expected return to a greater degree than the associated reduction in the risk profile. In the same article, MotleyFool.com goes on to suggest: “There’s no absolute cutoff point that distinguishes an adequately diversified portfolio from an over-diversified one. As a general rule of thumb, most investors would peg a sufficiently diversified portfolio as one that holds 20 to 30 investments across various stock market sectors. However, others favor keeping a larger number of stocks, especially if they’re riskier growth stocks. For example, some take a basket approach of investing in similar companies in an industry to make sure they don’t end up being correct on the thesis that the sector will rebound or grow at an above-average rate but choose the wrong stock that underperforms its competitors.”
In essence, research shows that a greater number of holdings does not reduce risk whatsoever and simply adds to investor confusion as they have no idea what they own and why they own what they own.
We believe that both advisors and investors should adhere to the famous Warren Buffett quote about the concept of over-diversification where he simply stated: “Wide diversification is only required when investors do not understand what they are doing.” Our belief is that this should not only be a word to the wise, but also a stern rebuke for this highly faulty practice.
Advisory Services offered through Nepsis, Inc.; An SEC Registered Investment Advisor.
