Over-Diversification: How Much Is Too Much?

It's essential for investors to have a diversified portfolio, which is a balanced collection of stocks and other investments across non-related industries. That's because those assets work together to reduce an investor's risk of permanent loss and their portfolio's overall volatility. The trade-off of diversification is an associated reduction in a portfolio's return potential.

However, it's possible to have too much diversification. Over-diversification occurs when each incremental investment added to a portfolio lowers the expected return to a greater degree than the associated reduction in the risk profile. In a sense, an investor can hold so many investments that instead of diversifying their portfolio, they've engaged in a bit of "di-worsification" where their portfolio is worse off because there's no added benefit to the incremental investments owned above a certain level.

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How much is too much?

How much diversification is too much?

There's no absolute cutoff point that distinguishes an adequately diversified portfolio from an over-diversified one. As a general rule of thumb, most investors would peg a sufficiently diversified portfolio as one that holds 20 to 30 investments across various stock market sectors. However, others favor keeping a larger number of stocks, especially if they're riskier growth stocks. For example, some take a basket approach of investing in similar companies in an industry to make sure they don't end up being correct on the thesis that the sector will rebound or grow at an above-average rate but choose the wrong stock that underperforms its competitors.

Instead of being an absolute number, over-diversification is more a function of spreading a portfolio too thin by investing in lower-conviction ideas for the sake of diversification. For example, not all investors need to own oil stocksortobacco stocks to have a diversified portfolio, especially if doing so would conflict with their values. Similarly, owning more than 100 stocks can make it difficult for an investor to keep up with their portfolio, which could cause them to hold on to losing stocks for too long.

Risks

What are the risks of over-diversification?

The biggest risk of over-diversification is that it reduces a portfolio's returns without meaningfully reducing its risk. Each new investment added to a portfolio lowers its overall risk profile. Simultaneously, these incremental additions also reduce the portfolio's expected return.

However, at some point, an investor will reach the number of investments where the benefit of risk reduction from each new addition is smaller than the decrease in expected gains. Thus, there's no incremental benefit to adding that investment. It would be better to sell a lower-conviction idea and replace it with this new one than add it to the portfolio since there's no incremental benefit.

The other danger of over-diversification is that it takes an investor's focus away from their highest-conviction ideas. They'll need to divert some of their time to stay up to date on all their holdings. That could cause them to focus too much on losing investments and not enough on the winners. It would be better to cultivate the winning ideas and add capital to those investments while weeding out bad ones that don't add an incremental benefit.

Avoiding over-diversification

How do I avoid over-diversification?

The best way to avoid over-diversification is for an investor to keep their portfolio to a manageable level. For some investors, that means only holding their 10 highest-conviction investments, so long as they're in various industries. For others, avoiding over-diversification means trimming investments in certain sectors (e.g., volatile materials producers,cyclical or industrial stocks, or hard-to-understand sectors such as biotechnology stocks) that they own simply for the sake of diversification.

Over-diversification can also mean owning shares in overlappingmutual fundsor exchange-traded funds (ETFs). For example, an investor who owns an index fund -- which holds 500 of the largest U.S. companies -- and an ETF of technology stockfocused on theNASDAQ Composite Index has over-diversified their portfolio. That's because the S&P 500 already has considerable exposure to information technology at nearly 28% of its total, including its five largest stock holdings. The best way for an investor to avoid over-diversifying with funds is to understand what they hold and sell a fund with similar holdings.

Too much diversification can make a portfolio worse

Diversification is essential because it reduces a portfolio's risk profile. However, since it also reduces its return potential, investors eventually reach the point where an incremental investment reduces the return potential more than the offsetting reduction in the risk profile. Because of that, investors should avoid over-diversifying their portfolio since it waters down their returns too much.

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FAQs

Over-Diversification: How Much Is Too Much? | The Motley Fool? ›

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How much diversification is too much? ›

Having Too Many Individual Stocks

A widely accepted rule of thumb is that it takes around 20 to 30 different companies to adequately diversify your stock portfolio. However, there is no clear consensus on this number.

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What is the average return on Motley Fool stock advisor? ›

Since launching in 2002, the Motley Fool Stock Advisor has delivered an average stock return of 644%*, significantly outperforming the S&P 500's 149% return in the same timeframe.

What does Warren Buffett say about diversification? ›

“Diversification is a protection against ignorance,” Buffett said. “I mean, if you want to make sure that nothing bad happens to you relative to the market… There's nothing wrong with that. That's a perfectly sound approach for somebody who does not feel they know how to analyze businesses.”

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Is 20 ETFs too much? ›

Holding too many ETFs in your portfolio introduces inefficiencies that in the long term will have a detrimental impact on the risk/reward profile of your portfolio. For most personal investors, an optimal number of ETFs to hold would be 5 to 10 across asset classes, geographies, and other characteristics.

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What is the 5% rule for diversification? ›

A high-level rule of thumb for avoid high levels of concentration is that a single stock should not make up no more than 5% of the overall portfolio. This is known as the 5% rule of diversification.

What is the 75 5 10 diversification rule? ›

Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.

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What is the paradox of diversification? ›

And its importance can often be forgotten due to specific biases we all can fall victim to. The paradox of diversification is that we're most likely to need it just when we feel we don't.

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What is the most famous quote to explain diversification? ›

My biggest investing mistake is encapsulated in a Buffett quote that many investors take too literally. "Diversification is protection against ignorance," Buffett said. "It makes little sense if you know what you are doing."

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Do billionaires diversify? ›

They don't diversify their investments right away.

But as the wealthiest people build their net worth, they often go all-in on their own projects, and then diversify as they start earning more.

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What is the 30 day rule on ETFs? ›

Tax-loss harvesting can be a great strategy to lower tax exposure but traders must be sure to avoid wash sales. You can't replace a security that you've sold at a loss by purchasing one that's substantially identical from 30 days before the sale until 30 days after it's complete.

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Is 7 ETFs too many? ›

"You can get broad-based diversification with one ETF, commonly referred to as diversified ETFs, or you can build a portfolio of five to 10 ETFs that would offer good diversification," he says. The choice you make on the above depends on your investment goals and risk appetite, like any investment.

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Is owning 100 stocks too many? ›

It's a good idea to own a few dozen stocks to maintain a diversified portfolio. If you load up on too many stocks, you might struggle to keep tabs on all of them. Buying ETFs can be a good way to diversify without adding too much work for yourself.

What is the 5 40 diversification rule? ›

Asset Diversification

of more than 5% cannot in aggregate exceed 40% of the fund's assets. This is known as the “5/10/40” rule. There are certain exceptions for government issued securities and for index tracking funds.

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What is high level of diversification? ›

The high-level diversification refers to a strategy that is adopted by the companies when they focus on using different strategies for different businesses.