Overdiversification: too much of a good thing?
When you invest in mutual funds, you get instant diversification as your money is spread across the securities held in that fund. But can diversification get out of hand? And if so, is it actually harmful for your investing goals?
Diversification is a time-tested way of dealing with investment risk. The idea is that by spreading your investments across a number of securities or types of investments you limit the effect of a decline in holding just one type. Most investors will know the most basic kind of diversification as holding fixed-income funds as well as equity funds so that a drop in one will be mitigated by the other. Diversification can also be achieved across asset types, geographic regions, company size, bond durations and many other factors.
Getting out of hand
But just as diversification mitigates the loss, it can mitigate the gain as well. That’s the first way that overdiversification can present a problem. Imagine that an equity fund holds the stock of 50 companies. If five of those perform exceptionally, it can provide a big boost to the performance of the fund. However, if the fund holds shares of 250 companies, the effect of those five outperformers may be blunted (depending, of course, on what percentage of the fund is held in each security).
A similar thing can happen within your own portfolio. When starting out you may have held just a few funds or even a single balanced fund. Over time, as you had more money to invest, you may have added new funds to increase your diversification or to take advantage of new opportunities or new investment products.
Sometimes this may be compounded by
the structure of the funds themselves. Some funds such as balanced funds have diversification build into the fund itself. Other multi-manager funds or “funds of funds” have diversification happening within individual funds and diversification happening at the fund of funds level.
Left unchecked, your portfolio can end up with needless duplication and unnecessary complications and administration. And
you may be blunting the effect of the
high performers in your portfolio. This
is over diversification, sometimes called
“diworsification” because it’s making things worse.
So, should you just simplify by cutting the number of funds you hold? While it certainly will make things less complicated, remember you want to maintain the benefit of true diversification: to manage risk by investing in a variety of investments that don’t behave in the same way.
One way to get closer to true diversification is by looking at how correlated this behaviour is by different types of investments. Mutual fund professionals can do this by looking
at correlation coefficients. Using this measure, two asset classes that are perfectly correlated, meaning they can expect to move in tandem, score +1.00. Those that are reversely correlated score -1.00, meaning they will move together but in opposite directions. A score of zero means there is no relation between the two variables.
For average investors, these correlations can show some surprising results. When looking at correlations with the S&P500, a broad measure of U.S. stocks, in the decade 2010 to 2019, Guggenheim found that International Equities (MSCI EAFE Index) had a score of 0.85 while Global Equities (MSCI World Net TR Index) scored 0.97.1 While both asset classes provide geographic diversification with the U.S.-based S&P500, they likely provide much less true diversification.
While surprising to most of us, professional asset managers know that in today’s globalized economy and investment markets, asset classes are more correlated than
they have historically been. This illustrates an important point for investors: while diversification is a relatively simple concept to understand, achieving meaningful diversification in your portfolio requires more knowledge and skills than ever.
What to do
To avoid overdiversification, remember that diversification is not just a matter of
“more is better.” In today’s world, it takes skill and access to information to get the benefits of true diversification. Professional portfolio construction provided through your investment funds advisor is the best antidote to this predicament.
Source: 1 Guggenheim Investments, Historical Correlation of Various Asset Classes vs. S&P500 January 2010-December 31, 2019.
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