Your Complete Guide to Index Investing with Dan Bortolotti

Can You Have Too Much Diversification?

2012-06-19T08:40:08+00:00June 19th, 2012|Categories: Indexing Basics|32 Comments

Is it possible for a portfolio to be too diversified? There are certainly a lot of articles making that claim. Investopedia even has one called The Dangers of Over-Diversifying Your Portfolio that concludes like this: “Diversification is like ice cream: it’s good, but only in reasonable quantities.”

Is the only free lunch in investing really just a fattening dessert? That depends on what type of investor you are.

Only active investors can overdiversify

The concept of overdiversification is only meaningful to investors bent on beating the market. If you’re a fund manager who is trying to outperform an index, it’s true that holding 100 stocks will make your job even harder than it already is. The more stocks you hold, the smaller the impact of your decisions, both good and bad. You might make a brilliant call on a company that doubles in value, but if that company makes up just 1% or 2% of your fund, the effect may be trivial.

An extremely overdiversified active fund manager is called a closet indexer: he or she holds a portfolio that closely resembles the benchmark, while charging fees that can be 20 times higher than an index fund. The chance of a closest indexer beating the benchmark over any meaningful period is close to zero.

A manager with a more concentrated portfolio—perhaps just 15 or 20 companies—at least has a fighting chance. When each stock makes up 5% to 8% of the portfolio, the big winners will have a meaningful impact. Indeed, there is some evidence that the less a portfolio resembles the index, the more likely it is to outperform. A well-known Canadian proponent of concentrated portfolios is Steadyhand: their Small-Cap Equity Fund, for example, includes just 17 stocks.

Index funds don’t dilute quality

So if you’re an active manager whose job depends on outperforming the market, then it clearly makes sense to be concerned about overdiversification. But if you’re a regular Joe or Jane who isn’t concerned about pleasing an investment committee, can you be too diversified? The answer is no.

It’s possible for a Couch Potato portfolio to be inefficient: for example, if you own two or more index funds that track similar benchmarks, your portfolio will be unnecessarily complicated and you’ll incur extra costs to rebalance. If an index fund incurred excessive trading costs trying to replicate a huge and unwieldy benchmark, that would also be a problem. But that’s not what most people mean when they talk about portfolios being “overdiversified.” A more typical argument goes like this:

“If you own 1,000 stocks you will have eliminated specific or unsystematic risk but your portfolio will not own the highest quality or best stocks… You might be better off owning 25 quality stocks among a variety of industries than own [sic] 50 quality stocks and 950 mediocre stocks that pull your portfolio performance down.”

This is nothing more than the tired argument that index investing is a poor strategy because “you get the bad companies along with the good ones.” While that sounds sensible, it assumes that investors can reliably identify the 25 “best stocks” from a universe of 1,000 or more, and that any added returns from these stocks will be sufficient to cover the cost of the research, transactions and taxes over the long term. This is possible, of course, but decades of data make it clear that it’s extremely unlikely, and that the overwhelming majority of investors fail in the attempt.

The equity ETFs in the Complete Couch Potato give investors exposure to about 10,000 stocks in more than 40 countries. Does this include “mediocre stocks that pull your portfolio performance down”? I suppose it does. But it also includes all of the companies that will ultimately deliver the highest returns. Until someone figures out a way to identify these two groups in advance, you give yourself the best odds by owning the whole market.

If diversification is like ice cream, then it’s fat-free and sugar-free with chunks of broccoli. The more you eat, the better off you’ll be.