21 Jul Why You Should Guard Against Over-Diversifying Your Portfolio

Understanding diversification

When referring to stocks, portfolio diversification means investing in different companies across various sectors and industries in a bid to bring down the risk factor.

While diversifying your portfolio is a wise thing for an investor and an effort at risk management, there is no guarantee that you won’t suffer losses. It is simply a sensible strategy to adopt by distributing your investments across different sectors or industries, you are effectively reducing chances for volatility.

This is due to the fact that not all industries or sectors will experience highs and lows at the same time. Thus, by mixing things up you can improve your portfolio performance. While risk is bound to stay, you can reduce it for individual stocks (unsystematic risk), but there’s nothing you can do for inherent market risks (systematic risks).

Can diversification take away risk?

The best way to measure risk is by observing the volatility of stocks. The more volatility, or more movement, a stock or portfolio shows within a given period of time, the higher the risks. A concept in statistics is called standard deviation which is used to measure volatility. Imagine that standard deviation here equals risk.

The modern portfolio theory states that optimal diversity can be achieved after adding the 20^th stock to your portfolio. While evidence proves that this might not be empirically true, it does reduce risk by about 29%. Additional stocks added after that will only reduce risk by 0.8%.

This is in direct contrast with the investors who think that the level of risk keeps coming down with each additional stock. The fact is that risk can only be reduced to a certain point and even portfolio management by diversification will not help.

Conclusion

In effect, diversification is good but only in reasonable amounts.  A good portfolio will contain approximately 20 stocks and is best for diversifying away maximum risk. Anything beyond that will negatively affect the big gainers, like large mutual funds which invest in 100 companies but diversify only within a certain sector or industry.

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