For years, financial professionals have touted the benefits of diversifying your investment portfolio. But now, some are warning that you can actually have too much of a good thing and over-diversify your portfolio.
"A diversified portfolio - one with a mix of investments spread across several sectors - reduces volatility without lowering expected returns," says Cesar Rainusso, vice president at BMO Investorline. "(However), holding more than 30 stocks in a portfolio can actually reduce the benefits of diversification by eliminating the investment risk essential for strong returns."
This idea that you can over-diversify your portfolio began to emerge during the crash of 2008.
"The pundits began to say then that diversification is dead because everything went down during the crisis," says Serge Pepin, vice president, investment strategy with BMO Global Asset Management. "It's in times like these, however, when a strong fixed income component can really help investors navigate the ups and downs in the market."
Over-diversification can be harmful in a number of ways and for a number of reasons.
Canadian investors in general tend to be over diversified because they have a strong domestic bias and tend to invest heavily in Canadian companies and equities.
While the TSX has outperformed markets in North America for the last seven years with the exception of 2011 and the first quarter of 2012, the Canadian market is small compared to the U.S. Only about 220 or so securities trade on the TSX, and of that number only about 75 are large cap equities, mostly in finance, energy and materials, explains Pepin.
"The average investor owns more than one Canadian large-cap fund, and since those funds tend to hold the same stocks in various weights, given our rather small market of available stocks, investors could be over-diversified in Canadian equity funds unless they hold both large and small cap funds," he says. "In the U.S., since the S&P 500 or the Russell 1000 are so much larger, owning two or three U.S. equity funds may mean better diversification."
Canadian investors have a tendency to have too many equities or funds, too many accounts (registered and non-registered), concentrate on too few areas of the market, and generally take a "sit-on-it-and-forget-it" attitude.
As well, because they are over-diversified, they may be paying more fees than they realize which could be hurting their returns.
"Because they are so diversified they tend to feel they don't have to worry about things and take this 'sit-on-it-and-forget-it' approach," Pepin says.
"Holding too many individual stocks can lead to added transaction costs without actually lowering investment risk," adds Rainusso. "It may be more efficient to simply select about 30 companies covering a range of sectors such as financials, utilities, technology and health care."
While there's no optimum number of stocks to hold in a portfolio, experts suggest between 10 and 30 stocks should provide some level of diversification and the probability of reduced risk.
A diversification strategy can be somewhat different for mutual funds.
"Canadian equity mutual funds tend to have similar holdings, including large positions in the banks and resource companies which dominate out market," Pepin says. "This overlap adds costs and complexity to a portfolio."
Pepin suggests holding one or two core equity mutual funds each with 30 or more companies.
"To avoid over-diversification with mutual funds, it's wise to choose funds with few redundant holdings and complimentary strategies," Pepin says. "This way you ensure you get all of the risk reduction that comes from diversification without diluting the benefits."
Pepin believes a portfolio should contain four main building blocks - a fixed income component of anywhere from 10 to 40 per cent to protect against the downside, and diversified Canadian, U.S. and international equities to provide growth.
Investors looking to reduce fees increasingly are using discount brokerages or, in many cases, trading themselves online.
While they might be reducing the costs of fees, there's a danger they may over-trade and move in and out of the market or securities too often and hurt their returns.
"Studies show that self-directed investors don't stay in as long as they should and are more active than they should be," says Pepin. "Switching too much can hurt you - you won't get ahead. It's not for everyone."
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors.
