Investing Basics

Diversification: Potentially Useful, But Sometimes Overused

Diversification is one of the main mantras of the modern financial world. Today's investors are taught that the surest way to defend against loss is to spread their money across as many securities as possible. Although it can be a helpful tool, the modern obsession with diversification—has gotten overdone.

The Modern Obsession With Diversification

The theory of diversification is based on very sound logic—to avoid losing everything if one investment faces calamity, investors should not put all their eggs in the same basket. Modern investors, however, are made to believe that owning as many investments as humanly possible is ok and has no less potential than owning fewer, this is incorrect. The more investments they own, the story goes, the more diverse their portfolios become and the more insulated they are from loss.

The problem with this logic is threefold.

  1. More is Not Always Better

    Academic research shows that diversification can work, but only to a certain point and only in an effort to mitigate company risk—not market risk or systematic (like when the big brokerages and auto industry failed in 2007-2009) risk. Studies by both Meir Statman and Evans and Archer reveal that the benefits of diversification rapidly diminish after the first 10 stocks. Owning 10 well-selected stocks may significantly diminish some company risk. Stocks 11-40 have marginal (very little) impact as well. After 40, there is no discernable benefit.

    It is important to restate that these benefits pertain only to the mitigation of company risk. No amount of stocks can diversify away market risk or systematic risk. What this means is when a crash happens almost all stocks go down a lot, and at once. Another term you will here is all assets were correlated or there was no place to hide. This is why a stock market crash strategy is important. Knowing how to get in and out of markets before crashes happen, when possible, might provide gigantic benefits if done properly.

  2. The Risk of Over-diversification

    Today's stock funds contain not between the necessary 10 and 40 stocks, but often between 100 and 200 stocks. Between their 401(k)s and their personal holdings, the average investor often owns multiple investment funds. Investors who own index funds are likely to own between 500 and 2,000 stocks in each fund.

    This intense saturation leaves the modern investor over-diversified and shackled to the performance of the market (called market returns). As the market goes all the way down, the over-diversified investor in that asset class goes all the way down right along with it.

    Some events—such as 9/11, World War I, and bank runs like those in the U.S. in 1907 and Greece in 2015—result in market downturns that have nothing to do with the performance of individual companies. During these downturns, the over-diversified stock market investor has nowhere to hide unless they sell early and go to cash.

  3. The Risk of Lost Opportunities

    Finally, by blanketing the market and purchasing hundreds or thousands of stocks in the useless pursuit of over-diversification, investors lose some control of their holdings and might miss out on opportunities to harvest larger potential returns (called alpha, or return above the market return).

    Some diversification can be a useful tool in attempting to mitigate company risk. In its simplest form, diversification is a defense mechanism that investors use to avoid losing all their money at one time, in one investment. Modern investment products, however, often over-diversify investors and leave them at the mercy of systematic market risk.

Like so much information cluttering the industry, the mantra of diversification is packaged and distributed by the very firms that stand to benefit from it the most.

Article tracking number 1-511387

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