Over Diversification cover

Why Over-Diversification can be Dangerous for your Stock Portfolio?

“Wide diversification is only required when investors do not understand what they are doing.” — Warren Buffett on Diversification

If you read any investing book or listen to a popular investment advisor, the first tip that most of them will give you is to diversify your portfolio. “Do not put all your eggs in one basket!!

At first glance, this tip sounds logical. After all, risks involved while investing in just one stock is way higher compared to if you diversify your investments in ten stocks. However, the problem occurs when people over diversify their portfolio.

Over-diversification is a common mistake among the investing population. In this post, we are going to discuss what exactly is over-diversification and how over-diversification can be dangerous for your stock portfolio. Let’s get started.

What is diversification?

A diversified portfolio is investing in different stocks from dissimilar industries/sectors in order to reduce overall investment risk and to avoid any damage to the portfolio by the poor performance of a single stock.

Ideally, a retail investor should hold stocks between 3 to 20 from different industries and sectors. However, personally, I believe 8–12 stocks are sufficient for a diversified portfolio. It’s crucial that your portfolio is sufficiently balanced as ‘over’ and ‘under’ diversification are both dangerous for the investors:

  • Under diversified portfolio has more risk as the poor performance of a single stock can have an adverse effect on the entire portfolio.
  • On the other hand, over-diversified portfolio gives low returns and even the good performance of a few stocks will lead to a minimum positive impact on the portfolio.

Ironically, Peter Lynch described it as ‘diworsification’ highlighting inefficient diversification, in his best-selling book ‘One up on the Wall Street’.

Why do people over diversify?

Over diversifying simply means owning an excessive number of stocks in your portfolio. If you are a retail investor and holding 30–40 stocks or more, you are over-diversifying your portfolio. Now, the next question is why do people over diversify their portfolio.

The most common answer can be that a lot of investors do not even know that they are over-diversifying. They just keep buying stocks following the famous traditional tip written in popular books i.e. diversify to reduce risk. They believe that having more stocks is good for their portfolio.

A similar thing happened to me during my rookie days. At one time, I had 27 stocks in my portfolio. Out of them, I had invested almost equally in among 18 stocks and the rest 9 were trailing stocks which contributed only a minor portion of my portfolio.

Although the returns from many of my holding stocks were high, however, the overall return on my portfolio was not that big during that period. Anyways, after a few months, when I analyzed my portfolio to understand why this was happening, I found the answer. I over-diversified my portfolio. In the upcoming months, I slowly reduced the number of my holding stocks from 27 to 14, keeping only the best ones which I was confident about.

Quick Note: An amazing book that helped me to understand that the concept of over-diversification is flawed was reading ‘The Dhandho Investor’ by Mohnish Pabrai.

The principle that I liked the most in this book was ‘Few bets, big bets, and infrequent bets’. Here, Mohnish Pabrai suggests that you do not need to make frequent bets. Every once in a while, you’ll encounter overwhelming odds in your favor. In such times, act decisively and place a large bet. If you haven’t read ‘The Dhandho Investor’ yet, I would highly recommend you to read this book.

Security

Another big reason why people over-diversify their portfolio is to have ‘security’. Buying a large number of stocks helps in spreading investment risks over many instruments.

If you diversify your portfolio with multiple stocks, you’re less likely to experience major drops. This is because the possibility of all the stocks underperforming at a particular time is quite less. When some of your stocks are having tough times, others may be out-performing. Hence, efficient diversification helps is maintaining consistent overall portfolio performance.

For defensive investors, security may be a reason for over-diversifying. It definitely reduces the risk, but it also decreases the expected returns. High returns on your best stocks will be always balanced out with the majority of average/losing stocks.

Why over-diversification can hurt your stock portfolio?

By now, you might have vaguely understood the concept of over-diversification, let’s discuss why over-diversification can hurt your stock portfolio.

  • Low expected Returns

Over diversifying or adding too many stocks to your portfolio reduces the risk, but it also reduces the expected returns. Let’s understand it better with the help of two extreme situations.

When you own 2 stocks, your portfolio is associated with high risk and high expected gains. On the other hand, when you own 100 stocks, your portfolio risk is low, but your expected gain is also lower.

Over-diversification is a point where the loss of expected return is higher than the benefit of reduced risks. For a well-diversified portfolio, you need to find the sweet spot where you neither own too many stocks nor too few.

  • Tracking them all is difficult

In order to efficiently monitor your invested stocks, you need to evaluate their quarterly reports, annual reports, corporate announcements, latest news related to the companies, etc. If you are holding 30 stocks in your portfolio, monitoring them all can be really difficult, especially for the retail investors who have a full-time day job.

On the other hand, if you are holding just 10 stocks in your portfolio, monitoring them doesn’t take too much time or efforts. However, when the number of holding stocks increases, the chances of missing important news/announcement related to your invested stocks gets higher.

  • Duplication or inefficient diversification

Diversification means owning different companies from different industries or sectors. For example, one stock from automobile sector, two stock from technology industry, one stock from pharmaceutical, two from banking, two from energy sector, etc.

However, if you’ve bought 5 banking stocks out of 10 stocks in your portfolio, you haven’t diversified your portfolio effectively. Over-diversification often leads to owning similar companies in your portfolio.

Closing Thoughts

The majority of the investing population are given flawed tip to immensely diversify their stock portfolio. However, following this strategy is quite dangerous for retail investors. Your portfolio should be sufficiently diversified, not ‘over’ or ‘under’ diversified.

That’s all for this post. I hope it was useful for you. Happy Investing!