Under Diversification
Under diversification, within the scope of portfolio theory, refers to a situation where an investment portfolio holds an insufficient number or variety of assets, leading to an elevated and unnecessary level of risk. While diversification aims to mitigate specific risks by combining different assets, under diversification leaves a portfolio unduly exposed to the adverse movements of a few holdings. This lack of adequate diversification can arise from various factors, including behavioral biases, limited capital, or a deliberate but often risky investment strategy to concentrate holdings for potentially higher return.
History and Origin
The foundational principles highlighting the dangers of under diversification can be traced back to the work of Harry Markowitz, who introduced Modern Portfolio Theory (MPT) in his 1952 essay "Portfolio Selection." Markowitz's work revolutionized investment management by mathematically demonstrating how combining assets could reduce overall portfolio risk, not just individual asset risk, by considering their correlation. He showed that the total risk of a portfolio is not merely the sum of the risks of its individual components but also depends on how those components move in relation to each other. His insights into the benefits of combining assets, for which he later shared the Nobel Memorial Prize in Economic Sciences in 1990, laid the groundwork for understanding the pitfalls of neglecting diversification10, 11. Prior to Markowitz, the focus was often on selecting individual "good" stocks; his theory shifted the focus to the overall portfolio and the importance of spreading investments to manage volatility9.
Key Takeaways
- Under diversification exposes a portfolio to higher levels of idiosyncratic risk, which is risk specific to individual assets and can be mitigated through proper diversification.
- It often results from an investor concentrating their capital in a few investments, rather than spreading it across a broader range of asset classes, industries, or geographies.
- The primary consequence of under diversification is the potential for significant losses if one or a few concentrated holdings perform poorly.
- While it may offer the potential for higher returns if concentrated bets perform exceptionally well, it equally amplifies the potential for substantial losses.
- Effective asset allocation aims to create a portfolio that balances risk and return objectives by diversifying across different asset types.
Interpreting Under Diversification
Interpreting under diversification involves assessing the degree to which a portfolio's returns are dependent on a limited number of assets or market segments. A portfolio exhibiting under diversification will likely show a higher volatility than a more diversified one with similar expected returns. This heightened sensitivity means that the portfolio's value could swing dramatically based on news or events affecting just a few companies or industries.
The goal of diversification, as illuminated by academic research, is to eliminate or significantly reduce unsystematic (or idiosyncratic) risk, which is specific to a company or industry. Systematic risk, on the other hand, is market-wide and cannot be diversified away8. An under-diversified portfolio fails to fully capture this benefit, leaving investors vulnerable to company-specific downturns that could have been softened by holding a wider array of investments. The Federal Reserve Bank of San Francisco has highlighted how effective diversification, even across different markets, can reduce portfolio risk7.
Hypothetical Example
Consider an investor, Alex, who believes strongly in the future of electric vehicles and decides to invest 80% of their $100,000 portfolio into shares of a single electric vehicle manufacturer, "EV Innovations Corp." The remaining 20% is held in cash.
In this scenario, Alex's portfolio is severely under diversified. If EV Innovations Corp. announces a major product recall or faces intense competition, its stock price could plummet. A 20% drop in EV Innovations Corp. stock would lead to a $16,000 loss (0.20 * $80,000) for Alex, eroding a significant portion of their total portfolio value.
Conversely, if Alex had opted for a diversified portfolio management approach, spreading the $80,000 across 20 different companies in various sectors (e.g., technology, healthcare, consumer staples, utilities), the impact of a single company's poor performance would be significantly diluted. For example, if one of those 20 companies fell by 20%, the impact on the overall portfolio would be minimal (only 1/20th of the $80,000 * 20% = $800 loss), assuming the other holdings remained stable or performed well. This example illustrates how under diversification amplifies exposure to company-specific events.
Practical Applications
Under diversification can manifest in various real-world investment scenarios. For individual investors, it often appears when they hold a substantial portion of their wealth in employer stock, either through stock options, restricted stock units, or 401(k) plans. This can create a dual risk: not only is their job tied to the company, but their financial future is heavily dependent on its stock performance. Many financial institutions advise against such concentration due to the heightened risk tolerance it implicitly requires.
In the realm of institutional investing, regulatory bodies often impose rules to prevent under diversification for certain investment vehicles. For example, the U.S. Securities and Exchange Commission (SEC) outlines specific diversification requirements for mutual funds. A "diversified" fund, as defined by the Investment Company Act of 1940, must meet certain criteria, such as investing no more than 5% of its total assets in the securities of any one issuer (with exceptions for government securities) and owning no more than 10% of any issuer's outstanding voting securities, for at least 75% of its assets4, 5, 6. These rules are designed to protect investors by ensuring a minimum level of diversification within professionally managed funds.
Limitations and Criticisms
While often detrimental, some investors might intentionally engage in under diversification, sometimes referred to as a "high-conviction" strategy, believing that their concentrated bets will yield superior returns. This approach relies heavily on exceptional stock picking or market timing abilities, which are notoriously difficult to achieve consistently, even for professional investors. The financial industry generally views such strategies as carrying substantially elevated risk.
A notable historical example illustrating the dangers of under diversification is the collapse of Enron in 2001. Many Enron employees had a significant portion of their retirement savings, particularly their 401(k) plans, heavily invested in Enron company stock2, 3. When the company's financial fraud came to light and its stock price plummeted, thousands of employees lost not only their jobs but also a substantial portion, if not all, of their retirement nest eggs due to their concentrated exposure. This catastrophic event underscored the critical importance of proper diversification, especially for retirement savings, and served as a stark warning about the risks associated with excessive reliance on a single corporate entity1.
Under Diversification vs. Concentrated Portfolio
While both "under diversification" and a "concentrated portfolio" involve a portfolio holding fewer assets than a broadly diversified one, the terms often carry different connotations regarding intent and risk management.
Under Diversification typically implies an unintended or unwise lack of sufficient diversification, often leading to excessive and uncompensated risk. It suggests a failure to adequately mitigate idiosyncratic risk that could otherwise be diversified away. This might happen due to ignorance of portfolio theory, insufficient capital to spread widely, or emotional attachment to certain investments, which falls under the purview of behavioral finance.
A Concentrated Portfolio, on the other hand, usually refers to a deliberate investment choice by an investor or fund manager to hold a limited number of securities, often with the belief that these specific holdings will outperform the broader market. While still carrying higher risk than a highly diversified portfolio, the implication is that this concentration is a calculated strategy, often with a deep understanding of the chosen securities. However, even a deliberate concentrated portfolio still faces amplified idiosyncratic risk compared to a more diversified approach.
FAQs
What causes under diversification?
Under diversification can stem from several factors, including lack of awareness about the benefits of diversification, limited capital that restricts the number of different investments an individual can make, or behavioral biases like overconfidence in specific investments. Sometimes, it can also be a deliberate, high-risk choice.
How many stocks do I need to be diversified?
While there's no magic number, academic studies suggest that much of the benefit of diversification in reducing idiosyncratic risk can be achieved with a portfolio of 20 to 30 well-chosen, non-correlated stocks across different industries and sectors. For broader protection and to manage systematic risk exposure, investing in diversified funds like mutual funds or exchange-traded funds (ETFs) that hold hundreds or thousands of securities is generally recommended.
Is under diversification always bad?
While under diversification significantly increases portfolio risk, it is not "always" bad in every single instance. For some investors with extremely high risk tolerance and a deep understanding of specific, highly undervalued assets, a concentrated position might lead to outsized returns if their conviction proves correct. However, this is a rare outcome and comes with a commensurately higher risk of substantial losses. For most investors, under diversification is detrimental to long-term wealth building and preservation.
Can under diversification affect my retirement?
Yes, under diversification can severely impact your retirement savings. If a significant portion of your retirement funds is concentrated in a few assets, especially employer stock, the poor performance or collapse of those assets could wipe out years of savings, as seen in historical cases like Enron. Asset allocation and proper diversification are crucial for securing retirement.