Are you investing in too many funds? Why diversification can cost you

Are you planning to invest in your stocks and shares ISA or pension before the current tax year ends? If so, it’s a good time to take a step back and evaluate the overall balance of your portfolio.

Ask investors how they manage risk, and you’ll probably get the same answer from each: diversification. Warren Buffett once said, “Diversification is protection against ignorance.” That sounds like a good strategy. Except he went on to say, “It makes little sense if you know what you’re doing.”

Using my own portfolio as an example (of what not to do), I’m going to explain why and how diversification can cost you money and how your ideal portfolio could look.

[top_pitch]

Why can diversification be a bad thing?

Diversification spreads risk. You can invest your money across a range of companies, sectors and countries. If one fund takes a hit, hopefully, your other funds will out-perform to balance it. All sounds good.

Except that diversification is a double-edged sword. You may have spread your risk, but you’ve also compromised your potential returns.

What’s more, if you hold a number of funds, then you end up replicating a tracker or index fund. And you paying for the privilege of doing so. The annual costs for passive funds are typically 0.1%-0.2% compared to 0.5-1.0% for active funds.

How can diversification dilute returns?

I’m going to take a critical look at my own portfolio to show how over-diversification has compromised my potential returns.  

I hold around 60 funds and investment trusts across my stock and shares ISA and pension with Hargreaves Lansdown. Their X-ray analysis is useful for identifying overlaps, providing a portfolio breakdown by region, sector and even company.

I hold 14 UK and 13 global actively-managed funds in my portfolio. The table below compares their performance against the highest-performing tracker funds, using data from Trustnet.

I’d have achieved higher growth by investing in a single global tracker than my selected global funds. However, I had more success with UK funds, delivering almost double the return of the FTSE tracker.

But in reality, over-diversification has limited my potential returns. If I’d picked my three top-performing funds in each of the UK and global sectors, I would have been rewarded with three-year returns of 79% and 87% respectively. Even my three lowest-performing UK funds would have achieved a respectable three-year return of 35%.

While holding a large number of funds spreads the risk of some funds underperforming, investing in a concentrated portfolio can also reward investors.

What’s the ideal number of funds?

One of the benefits of funds is diversification. You’re investing in a bundle of companies picked by experts. However, funds are already diversified. Spreading your money across funds means you’re holding hundreds, if not thousands, of underlying shares.

So how many funds do the experts recommend you hold?

• Maike Currie from Fidelity International suggests that for experienced investors with a £100,000 plus portfolio, holding “between 10 and 15 funds is more than enough”. She also advises a minimum fund size of £5,000 and limiting your exposure to 15% in any one fund.
• Moira O’Neill from Interactive Investor recommends between eight and 10 funds by choosing one fund from each asset class.

Another option is to invest in a tracker or index fund. These are passively managed, so they charge lower fees. While they may not beat the top-performing actively managed funds, they can provide solid returns when stock markets are rising.

[middle_pitch]

How do you choose which funds to invest in?

It’s worth taking the time to pick your ISA provider carefully. We’ve created a list of top-rated stocks and shares ISAs, most of which provide extensive information and advice about fund selection.

One of our top-rated providers, Hargreaves Lansdown, produces a Wealth Shortlist of their recommended funds by sector. They also offer ‘ready-made portfolio’ options plus ‘multi-managed’ funds if you don’t want to pick your own funds.

Trustnet is also a useful resource for picking funds, providing information about past performance against funds in the same sector.

Takeaway

It’s tempting to diversify investment portfolios to guard against the downside risk of one fund underperforming. However, a concentrated portfolio of 10-15 funds may offer the potential for higher returns.

On that note, it’s time to take action on my portfolio…