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

By Trader Pit

July 8, 2021


Over the last decade, the stock market has been growing. In fact, the average annual return of the S&P 500 has been about 10.6% over the last ten years. That’s pretty good, but it’s not even close to the 20.9% return that the average investor has gotten over the last decade. So, it’s easy to see how the average person can get lured into the stock market and lose their shirt.

When it comes to investing, most of us want to diversify our investments into several different types of assets. We do this to reduce our risk of losing money and hopefully increase our chances of making gains. However, the over-diversification of your portfolio can be expensive, as it leads to more risk and less upside.

Understand why overdiversification can be dangerous for your stock portfolio: Sometimes we do something too much and instead of it benefiting us, it starts to affect us negatively. The same goes for buying too many shares. According to Warren Buffett:

Broad diversification is only necessary if investors don’t understand what they’re doing – Warren Buffett on diversification

If you read an investment book or listen to a popular investment advisor, the first piece of advice most of them will give you is: diversify your portfolio. Don’t put all your eggs in one basket! !! At first glance, this advice seems logical. After all, the risks of investing in one stock are much greater than those of investing in ten stocks. However, the problem arises when people over-diversify their portfolios.

Overdiversification is a common mistake among investors. In this article, we look at what overdiversification is and how it can be dangerous for your stock portfolio. Let’s get started.

What is diversification?

A diversified portfolio is an investment in different stocks from different industries/sectors to increase returns, increase exposure, reduce overall investment risk and prevent damage to the portfolio due to poor stock performance.

Ideally, an individual investor should own 3 to 20 stocks from different sectors and industries. Personally, though, I think 8 to 12 stocks are sufficient for a diversified portfolio. It is very important that your portfolio is reasonably balanced, as too much or too little diversification is dangerous for investors:

  • A poorly diversified portfolio is riskier because the poor performance of one stock can have a negative effect on the entire portfolio.
  • On the other hand, a portfolio that is too diversified will produce low returns, and even a good performance of a few stocks will have only a minimal positive effect on the portfolio.

Ironically, Peter Lynch wrote about diversification in his bestseller One up on Wall Street, in which he emphasized inefficient diversification. Similarly, if you are considering buying 50 stocks, it is best to invest in mutual funds.

Why do people overdiversify?

Overdiversification means you have too many stocks in your portfolio. If you are a small investor and own 30-40 or more stocks, you have over-diversified your portfolio. The next question is why do people over-diversify their portfolios?

Perhaps the most common answer is that many investors are not even aware that they are overdiversifying. They continue to buy stocks by following the traditional advice of popular books: Diversify to reduce risk. They think that having more stocks is good for their portfolio.

Something similar happened to me when I started out. At one point I had 27 stocks in my portfolio. Of those, I invested in 18 stocks almost equally, and the remaining 9 were second-tier stocks that contributed only slightly to my portfolio.

While the returns on many of the stocks I owned were strong, the overall return on my portfolio during this period was not so good. Anyway, a few months later, when I analyzed my portfolio to understand why this happened, I found the answer. I over-diversified my portfolio. Over the next few months, I gradually reduced the number of stocks I owned from 27 to 14, leaving only the best stocks I was confident in.

The amazing book that helped me understand that the concept of over-diversification is wrong was reading the book Investor Dhandho Mohneesh Pabraj.

The premise I liked most about this book: Few bets, big bets and irregular bets. At this point, Mohneesh Pabraj recommends not deploying too often. From time to time, you are faced with insurmountable obstacles that are in your favor. At such times, you need to act decisively and make big bets. If you haven’t read Investor Dhandho yet, I highly recommend reading this book.

– Other reason: Safety

Another major reason why people over-diversify their portfolios is the desire for security. By buying a large number of shares, you can spread the investment risk over a large number of instruments.

If you diversify your portfolio with many stocks, you are less likely to experience significant declines. After all, the probability of all actions being ineffective at any given time is quite small. If some of your stocks are going through tough times, others may benefit. Therefore, effective diversification helps to maintain consistent overall portfolio performance.

For defensive investors, safety can be a reason to over-diversify. This certainly reduces the risk, but it also reduces the expected return. High returns on your best stocks will always be offset by most average/lost stocks.

Why can overdiversification hurt your equity portfolio?

You may already have a vague idea of the concept of overdiversification. Let’s take a look at why overdiversification can be bad for your stock portfolio.

– Low expected yield

Overdiversification or adding too many stocks to a portfolio reduces risk, but also reduces expected return. Let’s understand this better with an example of two extreme situations.

If you own 2 stocks, your portfolio has high risk and high expected return. In contrast, if you own 100 stocks, the risk of your portfolio is low, but the expected return is also lower.

Overdiversification occurs when the expected loss of return exceeds the benefit of reducing risk. To build a well-diversified portfolio, you need to find a point where you have neither too many nor too few stocks.

– It is very difficult to trace them all

To effectively track the stocks you invest in, you should evaluate their quarterly reports, annual reports, company announcements, recent company news, etc. If you have 30 stocks in your portfolio, it can be very difficult to keep track of them all, especially for small investors who work full time.

On the other hand, if you only have 10 stocks in your portfolio, it doesn’t take much time and effort to track them. However, as the number of shares outstanding increases, so does the likelihood that you will miss important news/announcements about your invested shares.

 

Short note
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Also read : How many stocks should I hold for a diversified portfolio?

– Ineffective duplication or diversification

Diversification means owning different businesses in different industries or sectors. For example: one share in the automotive sector, two shares in the computer sector, one share in the pharmaceutical sector, two shares in the banking sector, two shares in the energy sector, etc.

On the other hand, if you have bought 5 bank shares out of 10 shares in your portfolio, you have not effectively diversified your portfolio. Overdiversification often leads to similar companies in your portfolio.

Final thoughts

Most investors are given the wrong advice to massively diversify their stock portfolio. However, following this strategy is very dangerous for retail investors. Your portfolio should be sufficiently diversified, but not too diversified or too undiversified.

So much for this post. I hope this was helpful. If you have any doubts about stock diversification, feel free to voice them in the comments. Have a great day and enjoy your investments!

Hello, my name is Kritesh (Tweet me here), I am a certified fundamental equity analyst with NSE and an electrical engineer (NIT Warangal) by profession. I am passionate about stocks and have spent the last four years researching, investing and teaching people how to invest in the stock market. That’s why I like to share my knowledge with you. #HappyInvesting

Frequently Asked Questions

What are the dangers of over diversification in investment?

Over-diversification is the practice of holding too many different types of investments in order to reduce risk. It can be tempting to try to reduce risk by investing in a variety of different assets, such as stocks, bonds, and real estate. However, over-diversification can cause a portfolio to be less efficient and less profitable.

What happens when you over diversify?

The more you diversify, the more risk you take. The more risk you take, the greater the chance of losing money. If you over diversify, you may have a large portfolio with many different investments. This can cause you to lose money because you are spread too thin.

Can your portfolio be too diverse?

No, your portfolio can’t be too diverse.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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