Can You Be Over Diversified

post from Free Money Finance on 13 May 2008 05:05:00 PM. © Free Money Finance

Diversification is one of the key principles of investing. You want to spread your money among different assets types in an attempt to limit risk and enhance return. The thought is that if the market is bad for one type of asset, that it will likely be good for a different type. And if one investment is very risky, another is solid and steady no matter what. In the end, you get a nice balance and a fairly stable portfolio.

So is it possible that you can have too much of a good thing? Can you over-diversify? Yep. At least that's what Bankrate suggests. Their thoughts:

Financial industry experts agree that over-diversification can actually thwart your investment goals in the long run, as too many securities or mutual funds can diminish portfolio performance, increase costs and create an overwhelming amount of work for advisers and investors.

Ok, so what are the steps to having a well-diversified portfolio? It starts with asset allocation:

Creating a proper asset allocation is the first step in determining the right amount of diversification, according to Pat Swanson, Iowa State University extension specialist. "By having an asset allocation plan, you are able to look at your time horizon, consider risk tolerance, and have a collection of stocks, bonds and cash that will help you meet your investment goals."
The way to maximize returns while minimizing risk is to invest across different sectors, countries, asset classes or other criteria, says Jim Flinchum, president of Bay Capital Advisors in Virginia Beach, Va.

Then, you HAVE to also pay attention to costs:

Candura cautions investors that overall performance can be further eroded by unforeseen trading costs or taxes associated with a portfolio that has too many holdings. If you are paying for trades or sales charges, managing an excessive number of stocks or funds can be expensive or prevent you from missing breakpoints.
Similarly, high turnover in a taxable portfolio can create an expensive tax bill at the end of the year if the consumer is not paying attention.

Finally, you can select a handful of investments that give you good diversification but not something over-the-top:

While the precise number of individual securities, mutual funds or other investments in a person's portfolio depends on a variety of factors, there are some generally held opinions of how much is enough. Countless studies have found that 15 to 20 randomly selected stocks are adequate to diversify a portfolio and protect against non-market-related risk. Additional securities do not help to reduce the total risk in the portfolio and tend to buffer the potential gains any one could add.
Swanson says the number can vary, but recommends no more than 10 to 12 stocks. She points out that those stocks need to represent different sectors, company sizes, and other factors in order to provide proper diversification.
Mutual funds are different than individual securities because they create diversification in and of themselves, says Candura. He points out that if you pick good funds in the first place, there is no need to have multiple funds with the same objective. Holding funds that have the same goals increases the probability that you'll own the same stocks in numerous funds, creating significant overlap or redundancy. It is more important to pick a top fund to correspond to each asset class.
Swanson suggests that a typical, novice investor start with just one or two funds.
"You need at least four asset classes represented," says Flinchum. He recommends small cap, mid cap and large cap domestic stocks, and some international exposure.

And a few more points to note:

The larger the portfolio, the more investments might be needed in order to create the proper allocation. In those instances, the asset allocation may be further broken down to include subcategories of asset classes, specialty asset classes, like commodities, or alternative investments. Even then, however, selecting the best investments in each category rather than loading up on too many investments that do the same thing is the key to creating a portfolio with adequate risk control.
"An investor needs good diversification but not excessive diversification," says Candura. "Don't add more complexity than you need." While you don't want to put all your eggs in one basket, you also don't need too many eggs.

A couple thoughts from me:

1. One simple solution is to invest using only index funds. You only need a few funds to cover several asset classes, your costs will be held very low, and your portfolio will be easy to manage.

2. As I've noted before, I currently have too many funds. Many are left over from years ago and now have large capital gains associated with them if I sell. As such, I'm getting rid of them slowly by donating them to charity. I can attest to the fact that they are a MESS to manage, so follow the advice above -- don't do what I did. Or else, you could spend years trying to get back on a manageable course.