Diversification: Can You Have Too Much of a Good Thing?

Many, if not all, financial advisors will tell you that diversification is one of the best ways to keep the twin menaces of risk and volatility at bay, while protecting your portfolio from large losses in market downturns. The basic concept involves spreading your money across several asset classes and investment styles—essentially not putting all your eggs in one basket.

It's not bad advice. If you don't know whether stocks will continue to rally, if bonds will go bust, or when interest rates will start creeping up, diversification can help you hedge your bets. "There's only one free lunch," says Peng Chen, president of Ibbotson Associates, an investment consulting firm and subsidiary of Morningstar. "That's diversification." Having some parts of your portfolio perform well while others lag in a given market cycle helps offset market volatility and can smooth returns and reduce risk over the long term, he adds.

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But diversification is a fickle friend. Buying more and more mutual funds or ETFs isn't necessarily a good strategy, or even very efficient. In fact, an overdiversified portfolio can produce the opposite effect, stunting returns, increasing transaction costs and taxes, and amplifying risk.

But it's an easy trap to fall into, says Carl Richards, Park City, Utah-based financial planner and New York Times blogger, and happens when people become "collectors of investments" as opposed to just investors. Some simply buy what they think they should own, with little regard for how it contributes to their portfolio overall. "In the end you have a smorgasbord of unrelated investments, not linked to any purpose," Richards says. "You haven't decided on the destination before you picked the car."

The dangers of overdiversification. A bloated portfolio can have many negative impacts, including higher taxes and transactions costs, which can take a big bite out of returns over the long term. (More investments potentially means more trading, which can ratchet up transaction costs and capital gains taxes if profits are realized.) Keeping tabs on the contents of an overdiversified portfolio can be challenging as well.

Investors can also unwittingly concentrate risk in their portfolios by having too many investments. "[Overdiversification] gives you a false sense of security. You think you're diversified but you're not—it's a weird paradox," Richards says. "You could have five mutual funds that all own the same top five stocks." Genworth Financial Asset Management chief market strategist Christian Hviid agrees. "A lot of investors blindly assume that more is better," he says. "They assume they can throw things together and, as imperfect as that may be, achieve diversification, but there are hidden risks. You could actually be compounding risk as opposed to achieving more efficient diversification."

Hviid cites the effects of 2008's financial crisis, during which many investors who thought they were properly diversified ended up losing thousands of dollars as markets tanked. "Just throwing together a bunch of bonds, equities and commodities—they all share a lot fundamental drivers, the business cycle for one," Hviid says. "If we're contracting, all those things hurt. Unless you know exactly what you own, it's dangerous." It's not just any kind of diversification investors need, Hviid says. It's diversification of risk—essentially having some investments that don't correlate directly with each other, that zig while the market zags.

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On the flip side, splintering your portfolio into too many different funds and asset classes can dilute the impact of any one investment. "People buy things on whims," says Pete D'Arruda, CEO of Cary, N.C.-based Capital Financial Advisory Group. "If you get to a point where you have more than 20 stocks or mutual funds, you're getting to the point where you're actually minimizing returns instead of maximizing them."

Evaluate your portfolio. How do you know if you're overdiversified? Find out by taking a long, hard look under the hood of your portfolio, paying special attention to the types of investments you have. Chen recommends reconstructing your portfolio by asset class, drilling down into the contents of each fund you own. (Richards says tools like Morningstar's Instant X-Ray can help.) That way, you can pinpoint areas where you have too much concentration or not enough. For example, determine how much emerging markets or inflation-protected bond exposure your investments collectively provide by looking at the asset class breakdown of each fund.

Chen says investors should concern themselves more with the number of asset classes they have as opposed to the number of funds. "For the typical investor, if you have 10 to 15 asset classes covered, that's plenty," Chen says. "Then you say, 'OK, I want to cover 10 asset classes, so how many funds do I need to achieve that goal?' I would say if you have a 10-asset-class portfolio, maybe 20 funds."

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If you have more funds than that, it might be worth reviewing the investment objectives of each to see if significant investment-style or asset-type overlap exists, which can cause problems like overexposure to a particular sector and concentration of risk. If you find you have multiple funds with the same objective and similar performance, shed the less compelling ones and go with the cheaper choice, says Rob Hoxton, president and CEO of Shepherdstown, W. Va-based Hoxton Financial. He also cautions investors to be mindful of "style drift"—that mutual fund you bought years ago might not be the same, style-wise, today. "Maybe a particular fund claims to be a value fund, but when you pull the covers back and really take a look, it looks more like a growth fund," Hoxton says.

Above all, make sure your investments aren't past their prime. Investors commonly fail to reevaluate their asset mix to ensure that certain funds are still relevant and working toward their financial goals. "Compare it to a hot air balloon. If you keep putting things in the basket, the balloon is going to sink," D'Arruda says. "People should get rid of one [investment] before they buy another. You need to be more of a picker and less of a collector."

Twitter: @mmhandley