How much diversification is too much? |
|
|
|
Swanson says that if you have too many of a like kind of investment, such as a number of large cap stocks or mutual funds,
your return will end up reverting to the mean, or average, and you would have been better off in a passive investment strategy, such as an
index fund.
Flinchum argues that overdiversification can actually
lead to returns that are worse than an index fund, because, "The
portfolio might not be balanced to meet the index."
High 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.
Management problems
Having too many securities or funds creates a real management problem,
says Flinchum. He says that it is critical that either the investor
or his or her adviser know every security or fund in the portfolio.
"If neither understand it," he says, "it shouldn't be in there."
 |
| How much is enough? |
|
|
| • |
Generally 15 to 20 stocks. |
| • |
Or funds in four to five asset classes. |
| • |
Don't overlap mutual fund categories. |
|
What is the right number of investments?
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.
Each investor is different
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.
|
