Over diversification

What Is Over Diversification?

Over diversification refers to the practice of increasing the number of assets in an investment portfolio beyond the point where additional holdings contribute meaningfully to risk reduction. While diversification is a core tenet of sound financial planning and a key concept within portfolio theory, there can be diminishing returns and even negative consequences when the number of holdings becomes excessive. The primary goal of diversification is to reduce idiosyncratic risk, which is the risk specific to a particular asset. Once this risk is largely mitigated, adding more assets can lead to management complexities and diluted returns without significant further risk benefits.

History and Origin

The concept of diversification itself gained significant academic footing with Harry Markowitz's seminal work on Modern Portfolio Theory in the 1950s, which demonstrated how combining assets could reduce overall portfolio volatility. Early studies on the optimal number of stocks for diversification suggested that most of the benefits could be achieved with a relatively small number of holdings, sometimes cited as few as 8 to 10 stocks. For instance, a pioneering paper in 1968 posited that this range was sufficient to exhaust the economic benefits of diversification, a notion widely cited in textbooks for some time⁷, ⁸.

However, subsequent research has challenged and refined this view, suggesting that a larger number of holdings, potentially 30 to 50 stocks or even more, might be necessary to achieve maximum diversification effects in modern markets due to evolving market dynamics and lower transaction costs⁵, ⁶. Despite the evolving consensus on the "optimal" number, the underlying principle of over diversification—that adding too many assets eventually yields negligible benefits—has remained relevant. The idea stems from the point at which the benefits of spreading risk are outweighed by the costs or inefficiencies introduced.

Key Takeaways

• Over diversification occurs when adding more assets to a portfolio no longer significantly reduces risk or improves risk-adjusted return.
• It can lead to diminished returns as an investor's best ideas are diluted by less promising ones.
• Increased complexity and higher transaction costs are practical drawbacks of over diversification.
• The point at which a portfolio becomes over diversified is not fixed and can depend on market conditions, asset classes, and investment objectives.

Interpreting Over Diversification

Interpreting over diversification involves evaluating whether the current number and types of assets within an investment portfolio are still contributing to its overall goals. A portfolio is considered over diversified when the marginal benefit of adding another asset, in terms of reducing unsystematic risk, becomes negligible, or when it begins to negatively impact the portfolio's potential for robust expected return. This often means the portfolio's performance starts to closely mimic that of a broad market benchmark, effectively eliminating the potential for outperformance from specific asset selection.

One common interpretation is that a portfolio is over diversified if it holds so many individual securities that the investor loses the ability to adequately monitor each holding. For example, owning shares in hundreds of different companies might prevent an investor from staying informed about the fundamental changes affecting each one, effectively turning an active strategy into a de facto passive investing approach without the associated low fees of an index fund.

Hypothetical Example

Consider an investor, Alex, who starts with a portfolio of 20 carefully selected, high-conviction stocks across various sectors. This initial asset allocation provides a good level of diversification, mitigating much of the idiosyncratic risk.

Driven by a desire for even greater safety, Alex then decides to add 180 more stocks, bringing the total to 200 individual company shares. At this point, several issues arise:

1. Dilution of Conviction: The impact of any single winning stock on the overall portfolio performance becomes minimal. If one of Alex's original 20 high-conviction stocks doubles in value, its effect on a 200-stock portfolio is significantly diluted compared to a 20-stock portfolio.
2. Increased Management Burden: Alex now spends considerably more time researching, monitoring, and executing trades for 200 companies, a significant increase in effort for potentially negligible additional benefit.
3. Higher Costs: Each trade incurs transaction costs. With 200 individual positions, rebalancing or adjusting the portfolio becomes more expensive and cumbersome.

In this scenario, Alex's portfolio has moved into over diversification. While the additional 180 stocks might offer a minuscule further reduction in idiosyncratic risk, they likely introduce complexity and dilute potential gains without providing a meaningful increase in the portfolio's risk-adjusted return.

Practical Applications

Over diversification manifests in various aspects of investment management:

• Individual Investors: Many individual investors, particularly those managing their own portfolios, may inadvertently fall into over diversification by accumulating too many different stocks or funds in an attempt to be "safe." This can lead to a portfolio that performs very similarly to a broad market index but with higher fees and management effort than simply investing in an index fund. The Bogleheads Wiki advises against excessive holdings, noting that adding too many funds can negate the benefits of simplification and low costs.
• ⁴ Fund Management: Even professional fund managers can face challenges with over diversification. While large funds often hold a vast number of securities, the objective is typically to track a specific benchmark or to manage a broad asset class, which inherently requires many holdings. However, an actively managed fund with too many positions might find its performance converging towards the market average, making it difficult to justify its management fees.
• Portfolio Analysis: When analyzing an investment portfolio, financial advisors often look at metrics like active share to determine if a portfolio has enough distinct holdings to meaningfully deviate from its benchmark, or if it is effectively over diversified to the point of being a closet indexer.
• Regulatory Compliance: While not directly regulated as "over diversification," regulations often focus on adequate diversification to protect investors. The inverse, too much diversification, can make it harder for investors to understand what they own, potentially complicating due diligence.

Limitations and Criticisms

While diversification is crucial, over diversification has distinct limitations and criticisms. A primary critique is the dilution of returns. By spreading capital across too many assets, an investor's best ideas or highest-conviction investments have a proportionally smaller impact on overall portfolio performance. This can lead to "mediocrity" where the portfolio's returns approximate the market average, sacrificing potential alpha for negligible additional risk reduction.

Another significant drawback is the increase in complexity and management burden. Monitoring, researching, and rebalancing an overly complex portfolio with hundreds or thousands of individual securities can become time-consuming and inefficient. This increased administrative effort may not yield proportional benefits, leading to a suboptimal use of an investor's time and resources, essentially creating an opportunity cost.

Furthermore, increased transaction costs can erode returns. Each purchase and sale of an asset typically incurs commissions or fees. With a very large number of holdings, particularly for active traders or frequent rebalancers, these costs can accumulate and significantly drag down net performance.

Academic research has continued to explore the point of diminishing returns in diversification. Studies suggest that while early diversification efforts yield substantial risk reduction, the marginal benefit of adding more securities decreases sharply after a certain point. For instance, the Federal Reserve Bank of San Francisco noted in a 2007 economic letter that most of the diversification benefits in a stock portfolio are achieved with a relatively modest number of stocks. Be³yond that point, investors might be subjecting themselves to market risk—or systematic risk—which cannot be diversified away, without adequately leveraging the potential for higher returns from concentrated positions.

Over Diversification vs. Under Diversification

The confusion between over diversification and under diversification often stems from an investor's interpretation of "safety." An investor fearing single-asset risk might continuously add more assets, mistakenly believing that "more is always better" for safety. However, true portfolio optimization seeks a balance where risk is adequately mitigated without sacrificing potential returns or incurring undue costs and complexity.

FAQs

How many stocks indicate over diversification?

There is no universally agreed-upon precise number of stocks that constitutes over diversification, as it depends on factors like market dynamics and investor goals. However, academic research suggests that the majority of diversification benefits are achieved with a portfolio of 30 to 50 stocks, or even fewer for certain objectives. Beyond¹, ² a certain point, adding more individual stocks provides negligible additional risk reduction and can dilute potential returns, effectively mimicking a broad market index.

What are the main drawbacks of over diversification?

The primary drawbacks include the dilution of potential returns from strong-performing assets, increased complexity in managing the investment portfolio, and higher transaction costs from buying and selling numerous securities. It can also lead to a loss of focus and the inability to thoroughly research each holding.

Can over diversification hurt your returns?

Yes, over diversification can hurt your returns. While it effectively eliminates specific company risk, it also dilutes the impact of any exceptional performance from individual holdings. If a portfolio becomes too broad, its performance will tend to mirror the overall market, and any unique insights or strong investment ideas an investor might have will have a minimal effect on the total expected return. This can lead to an average return that may be further eroded by increasing expenses like management and trading fees.

Is over diversification relevant for mutual funds or ETFs?

Over diversification can be relevant for investors using mutual funds or Exchange-Traded Funds (ETFs) as well. While these funds are inherently diversified, an investor holding many different, overlapping funds might achieve over diversification at the portfolio level. For example, owning multiple large-cap U.S. equity funds from different providers might result in significant overlap in underlying holdings, negating the purpose of holding multiple funds and potentially leading to higher aggregate fees without added diversification benefits or improved risk-adjusted return.