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Why Over-Diversifying Can Cost Us Dearly

Diversifying a portfolio is a risky strategy.

By diversification, I mean buying, say, 20-plus different investments with the aim of mitigating the effect of potential losses.

That’s a dangerous approach to investing, which could lead to lacklustre returns at best or, worse still, capital loss over all.

I thought we are ‘supposed’ to diversify!

Traditionally, many see a diversified portfolio of shares as a defence against individual company risk, but too many shares in a portfolio can actually increase risk.

With too many shares, it’s hard to know the underlying businesses well. Do-it-yourself investing can be hard work. We need to follow the operational and strategic ups and downs of our investments and keep a finger on the pulse of valuations and investor sentiment if we are to distinguish investing from gambling.

Many of us private investors don’t do our investing full-time, so how can we keep tabs on 20-plus investments in our portfolios? Keeping up with ten investments at one time, my personal maximum, exhausts me, and I’m much more comfortable with around five. That’s still diversification, but it’s effective diversification because there’s much more chance of making well balanced, considered and timely ‘buy’, ‘hold’ and ‘sell’ decisions, and thus greater chance of building wealth through investing.

Diminishing focus

If we take on too many investments, there is risk that the quality of our choices might decline. With many holdings, we could end up chucking in a few speculative ones with hardly a thought, or relaxing our buying criteria, or failing to develop a well thought out rationale for buying.

When over-diversification diminishes the percentage of our capital allocated to any one decision, there is great risk that we diminish the quality of our decision-making similarly. Even if a determination to avoid such pitfalls exists, time constraints could mean we end up falling into that trap anyway.

With greater focus on just a few shares, it’s more likely that we will be on top of opportune moments for buying and selling. Initially operating with between five and 10 equally weighted investments can provide diversification whilst at the same time providing us with a realistic opportunity to build wealth through investing.

Those first five shares or investments will be our best ideas. Number 32 will, arguably, be down in the third-division of ideas and operate as an expensive and time-consuming distraction, as it sucks our attention from our best investments.

A long tail

Many investors don’t equally-weight their investments, instead, lending a nod to the ‘best idea’ theory, which sees greater allocation of capital to a ‘top five’ or a ‘top 10’ or some such; I used to do that a few years ago. However, that long tail of tens of smaller positions could be doing more harm than we realise. Those positions, that have minor effect on our portfolios, dissipate our attention. Such diffusion of attention could cause us to miss a vital cue in one of our larger holdings, which could prove costly.

If our first five to 10 investments truly are our best ideas, why not slough off that long tail and concentrate focus on just those five to 10? I did, around three-and-a-half years ago, and my overall investment performance improved.  

If we are holding 20-plus shares in a portfolio, shouldn’t we really ask ourselves if we’d be better off with a tracker or a fund?  If we have 20-plus small-cap holdings, for instance, why not buy a fund that tracks the small-cap index? Doing so would reduce the costs and time-input required and probably deliver a similar result to holding a wide diversification of 20-plus equally weighted positions in our own portfolio.

Conviction buying

I’m not going to diversify away my advantage as a private investor. Wide diversification of 20-plus or more investments makes little sense when so many trackers and funds are available as an alternative today. Over-diversifying in our own portfolios is risky because it takes our eyes off the important balls.

If we are involved in the stock market with the aim of building wealth by our own hand, we need to concentrate on backing quality decisions with meaningful amounts of capital. If we do that, the greater intensity of focus can lead to reduced risk anyway, without the need to attempt to protect ourselves, from ourselves, by over-diversifying.

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