Fewer is Better: The Dangers of Excessive Diversification

Remember our post on Less is More? Well, this week we’re discussing how Fewer is Better.

Did you ever try to create a color wheel in art class? Mixing colors usually worked when there were only two primary colors. You know: yellow and blue make green, red and blue make purple — that sort of thing.

But when you start mixing the secondary colors with primary colors, they seemed to lose some of their pureness. Yellow-green was more like a puce color. Red-orange was always too red or too orange.

It was hard to get the color to look just right.

Sometimes, our investment portfolio can be the same way. When we get too many different investments, we may think we are diversified, but the underlying investments may have too many of the same stocks. This makes our investment mix too tilted toward growth, or too much in bonds – and we don’t even realize it.

When investing, often simple is best.

But, since the virtues of diversification have been preached to the masses for years, that simplicity can be overlooked in favor of too much diversification.

As humans, we love the freedom of choice. However, research shows that too many choices actually lead to a decline in happiness. That’s why I contend that the fewer investment choices you have to make, the better your chances of experiencing success within your investment portfolio.

Now don’t get me wrong, the “don’t put all your eggs in one basket” philosophy of diversification is an excellent piece of advice that all investors should follow. However, diversification doesn’t necessarily mean more funds, it means fewer funds with the right array of underlying stocks.

Think about it this way: let’s say your portfolio has an S&P Index fund, an actively managed Large Cap Fund, and a Target Date 2055 Fund.

While you might appear diversified, you would actually be overloaded on Large Cap stocks.

And this is the case for many mutual fund holders.

Despite the overwhelming consensus that a well-balanced portfolio strikes the right balance of diversification and market risk, many mutual fund owners employ a more-funds-equals-more-diversification philosophy to their portfolio, which couldn’t be any further from the truth.

When investors include a number of different funds in each asset class to ensure they cover all their bases, what they’re really doing is turning their portfolio into an expensive index fund.

As a result, they’re taking away the potential of big gains that could otherwise significantly impact their bottom line.

The Bottom Line

Think of diversification in the same way you would dessert at Thanksgiving: a little bit here and there; you’re golden, too much and you’ll end up miserable.

But don’t just take my word for it, consider the words of one of the most successful investors of our time, Warren Buffett, on the subject.

According to Buffett, “Wide diversification is only required when investors do not understand what they are doing”. Put another way, if you diversify too much, you might not lose much, but you won’t gain much either.


Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.

Your Financial Mom blog posts are not meant to be legal, accounting or other professional service advice. Content represents the opinion of the author only. Pathfinder Planning LLC is not responsible for the accuracy or validity of content contained in third-party comments.

 

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