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The Dangers of Excessive Diversification

Spreading your assets too thin can hurt performance

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The virtues of diversification have been drilled into the heads of financial professionals and novices for the past fifty years. In some cases, investors have been told it doesn’t particularly matter what they own, but rather the type of asset (this, of course, is pure foolishness - there is a tremendous difference between the common stock of Berkshire Hathaway and that of American Airlines). Still, the concept of “don’t put all your eggs in one basket” is a wise one for those who are unable or unwilling to evaluate the attractiveness of investment opportunities. A good thing, however, can be carried too far. In fact, excessive diversification presents a serious hurdle to wealth building.

 

How much diversification is too much?

There are several dangers in acquiring more companies than can be reasonably monitored. How much diversification is too much? Generally speaking, the average investor should hold no more than twenty or thirty well-chosen, defensively selected investments. Excessive diversification presents the following problems (note that this limit does not apply to those engaged in risk arbitrage or the purchase of sub-working capital equities):

 

  • Lax standards
    The investor is more likely to loosen his standards and accept greater company or price risk because each represents a smaller capital commitment. Unable to periodically reevaluate each of his holdings, the investor does not notice significant deteriorations in margins or competitive position until his investment has lost substantial value.

     

  • Reduced impact of individual investments
    The investor’s capital is spread so thin that even an excellent investment has only a marginal impact on the total value of the portfolio. Consider that in a $100,000 portfolio with 100 different investments, any stock that doubled would result in an increase of only one percent (1%) - a paltry return to be sure!

 

Diversification without the hassle

If you want to hold a diversified portfolio without the hassle or frictional costs of selecting individual investments, consider HOLDRs, Diamonds, Spiders, or other basket investments. These securities trade just like stocks on the open market and are a type of exchange traded fund, or etf. The difference is, when you purchase a HOLDR, for example, you are beneficially buying shares in dozens of companies in a particular industry or sector. Investors that purchase diamonds are literally purchasing a fraction of each of the 30 stocks that make up the Dow Jones Industrial Average so with one trade, you're buying the Dow Jones. Each of these are excellent ways to build a diversified portfolio instantly while significantly reducing transaction costs and brokerage fees.

 

A note on portfolio rebalancing

You should never sell a stock merely because it has increased in price. In the world of diversification, the concept of so-called “rebalancing” has received far too much attention. If the fundamentals of the business (margins, growth, competitive position, management, etc.) have not changed and the price still appears to be reasonable, it is foolish to sell the holding for another business that does not possess the same attractive qualities even if it has come to represent a significant portion of the overall value of your portfolio. Famed money manager Peter Lynch called this practice, “cutting the flowers and watering the weeds”. Billionaire investor Warren Buffett tells us that, “the most foolish maxim on Wall Street is, "you can never go broke taking a profit’”.

Indeed, an investor that early on purchased shares of Microsoft or Coca-Cola as part of a diversified portfolio would have been made millionaires many times over if they had merely left these excellent businesses alone. There is only one primary rule of investing: In the long run, business fundamentals will determine the success of your holding if the security was purchased at a reasonable price.

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