No Diversification vs. too Much Diversification, How to Strike a Balance for your Investment?

In terms of investment, diversification is a method that can be defined as the lessening of danger of loss by investing in a variety of assets rather than investing the whole amount in one asset.

Investment Diversification

Diversification is needed because the prices of all the assets do not rise or fall at the same time, hence there is less risk of loss at an average level. Therefore, people who want to keep their rate of risk as low as possible diversify their investments, at least to some extent.

Example:

A very straightforward and easy example of diversification can be explained by the maxim “Don’t put all your eggs in one basket.” If you drop the basket, all the eggs will break at the same time. Meanwhile, diversifying the eggs in a number of baskets will reduce the risk of breaking all the eggs at once. There is the risk of losing one, or a few, eggs, but that risk is permissible compared to the risk of losing all of them.

In terms of finance, an undiversified investment strategy would be to invest all of one’s money in the stock of only one company. This is chancy; the company’s stock value can fall dramatically, causing one to lose all of the investment. Meanwhile, if money is invested in the stocks of more than 10 companies, the risk is lessened, as a few companies may profit, while the value of others may decreasing, resulting in “balance.”

No investment diversification

I can share my experience with no diversification. During the 2008 stock market crisis I put most of my stock investment money in just one stock Washington Mutual, when it became sub $10 stock I bought some, when it came down to $5, I bought some more. When it became a $2 stock I bought even more WaMu. On the very last day I bought a few thousand of WaMu at $0.80.

I thought WaMu was too big to fail and Fed won’t let WaMu fail like Lehman Bros. I lost quiet a few grands in the process. Till date this was my biggest investment failure and financial mistake. I don’t want to let that happen to any one else. Now I carefully do my investment (read where to invest my money).

People may think that diversifying investments reduces profit; when there is investment in more than one place, one option may result in profit and the other in loss, and the investor might feel that had he/she invested in one place, chances of profit would have been greater.The Apple stock may give you largest of profits, but, I would say if you’re only invested in Apple, get rid of some and buy other stocks.

People also tend to believe that if investment is made by closely studying the area of investment, diversification is not needed. Diversification can bind your profits if a certain company or sector goes through a period of unusual growth. Creating a properly diversified investment portfolio that guards you from all loss is unattainable.

Pros & cons of no investment diversification:

  • If you have invested in different divisions of the market that don’t move at the same pace, an increase in the revenue by the more profitable sectors will balance out price downfalls in the less profitable sectors of the market. Diversification also saves one from the harms of depressing surprise news on one of your investments.
  • Part of the advantage of not diversifying is in its straightforwardness. The investor chooses one, or at the most two, areas where he/she feels confident investing, and is satisfied with that.
  • There is no headache of everyday management, changing investments every day, keeping track of the stock market, etc.
  • On the other hand, investing all your money in one place is a large risk—if one’s luck runs out, the end result could be huge losses

Too much diversification

Diversification of money is good, no doubt and, there is no limit or figure that shows that too much diversification is negative. Nevertheless, at some point one will realize that further diversification is of no use. Adding more stocks to your investment ceases to make a difference.

About how much diversification are needed to reduce risk while maintaining high returns is debatable, and the most predictable view argues that an investor can attain the most advantageous diversification with 15 to 20 stocks spread across various industries.

Pros and cons of too much diversification:

  • If you have invested in different divisions of the market that don’t move at the same pace, an increase in the revenue by the more profitable sectors will balance out price downfalls in the less profitable sectors of the market. Diversification also saves one from the harms of depressing surprise news on one of your investments.
  • Diversification provides the advantage that if one of the investments results in a loss, your entire savings and investment won’t have been wiped out.
  • The disadvantage with diversification is that you won’t have the opportunity to make the largest return with your best investment—there is an upper limit along with the lower limit.
  • The most risky investments are those that are entirely based on luck—they may give you the maximum returns and largest profits or the maximum losses. However, if you have your investments in different sectors, then it is highly unlikely that you will receive huge gains on all of those investments.

How to strike a balance

It is always better not to go for the extreme sides of anything. Staying in the middle is the best way to play the game, along with avoiding at least 50% danger. Not diversifying your investments at all can result in huge losses at once, and diversifying too much can result in minimum profits.

Hence, it is better to diversify investments in a few sectors to avoid risk and also keep profits at maximum potential. US securities and exchange commission has a very valuable beginners guide to asset diversification, it’s a good read too. I want you to read it and make your own decision. Start investing now and never look back.

Readers, what extent of diversification you follow in your investment strategy? Like to share some example with us?

is a husband and working as a software professional for a Fortune 100 corporation in Florida. Thanks for visiting the blog.

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Comments

  1. says

    To your point, there are several downsides to over-diversification:
    1) Diligence – having an excessive number of positions requires significant time and resources to properly diligence the investments, not to mention the time required to monitor the portfolio on a consistent basis.
    2) Complicated tax situation – with a large portfolio of individual stocks, it can be cumbersome to manage the tax implications of trades, especially if you are contributing new funds periodically and rebalancing the portfolio. Minimizing the tax implications requires tracking tax lots of each security. If you don’t have proper record-keeping measures in place, this could be a nightmare.
    3) Cost – this is the biggy. With an excessive number of positions, transaction costs are going to cut into your overall returns. This can occur if you are (a) rebalancing periodically (always recommended), or (b) shifting the investment weights excessively in hopes of timing the market (not recommended). Either way, transaction costs are going to get you.

    I’m sure there are other reasons how over-diversification can hurt but I thought I would bring these up at the very least. A better way to go to achieve diversification without the burdens described above – invest in index ETFs or index funds (mutual funds offer diversification as well but at greater costs and generally underperform their benchmarks). You can target the sectors of the market you want and create a diversified portfolio in a handful of securities. MUCH easier to manage and track. Hope this was helpful.

  2. says

    You can tell what is too much if your investments are not balancing out and you have high returns and low returns around the same time.

    Pam

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  4. says

    Another reason to consolidate your holdings! I have most of my holdings with Vanguard and they have a great tool that compares holdings of different funds and shows you where you have overlap of similar asset classes. I also recommend holding fewer funds as you will most likely have similar holdings in multiple funds and that will hurt your performance.

    • says

      And I use Fidelity and TRowe Price for that. You are right I should be looking in to the fund composition at both more closely. Holding on TRowe and Fidelity should not be similar.

  5. Rinkesh says

    Nice information. I never give much importance to investment. My wife does take care of that. Hopefully from next month, I will take the charge in my own hand. :)

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