Are your investments too diversified?

Over-diversification increases risk, stunts returns, and raises transaction costs and taxes

Published: July 2014
Photo: Colin Anderson

Most financial advisers will tell you that diversification is the best way to protect your portfolio from risk and volatility. The basic concept of diversification is captured in the saying “Don’t put all your eggs in one basket.” But what if an investor has too many eggs in too many baskets?

Financial-industry experts also agree that over-diversification—buying more and more mutual funds, index funds, or exchange-traded funds—can amplify risk, stunt returns, and increase transaction costs and taxes. The fact is, says Dan Candura, a certified financial planner in Braintree, Mass., “you can have too much of a good thing.”

How it happens

Over-diversification often sneaks up on you. “Investors tend to be collectors,” Chris Philips, a senior analyst at Vanguard’s Investment Strategy Group, said. “They pick something up because they read about it or saw something on TV, and keep collecting and collecting” without considering the overall effect on their portfolio.

Many investors unwittingly over-diversify in their retirement accounts. Faced with a wide range of choices in an employer’s 401(k) plan offerings, “they take a little of this and a little of that, without thinking about overlap,” Philips said.

Craig Adamson, president of Adamson Financial Planning in Marion, Iowa, describes a typical case. As a result of changing jobs a few times, a client had three 401(k)s, a Roth IRA, and a regular IRA. A previous adviser had told him that he held no foreign stocks, yet after analyzing the portfolio, Adamson discovered that about 30 percent of the fund holdings were in international equities—a huge overweighting. “He thought he was diversified because he had money in three different 401(k)s and two IRAs, instead of looking at his underlying investments,” Adamson said.

Another common cause of portfolio imbalance is loading up on previous winners. Dave Yeske, managing director of Yeske Buie, a wealth-management firm in San Francisco and Vienna, Va., explains it this way: “People say, ‘I’m looking for the best-ranked funds from Lipper or Morningstar,’ but that will lead them to buy 10 of the same thing. Based on last year’s results, you’d end up with 10 funds investing in U.S. small-cap stocks. The year before, you’d have ended up with a portfolio full of global real estate.”

The drawbacks of over-diversification

Owning too many mutual funds can actually increase risk by concentrating your holdings in a few areas. A joke often told after the technology bubble burst was that investors thought they were diversified because they held Janus Twenty, Janus Mercury, and Janus Growth. In reality, recalls David Blanchett, head of retirement research for Morningstar Investment Management, “each of those funds held almost the same technology stocks.”

Even when you think you have spread your risks, it’s easy to hold funds with different strategies that in fact own large concentrations of the same stocks. For example, five of the top 10 holdings of an index fund tracking the growth stocks in the Standard & Poor’s 500 Index, ticker symbol IVW, are in the top 10 picks of a well-regarded technology mutual fund, VGT.

“People perceive funds to be like individual stocks,” Blanchett said. “With stocks, you want to hold 20 to 30 different ones. But if you buy three large-cap funds, now your portfolio is tilted to a large-cap asset class. You’ve created a portfolio that may appear diversified but really isn’t.”

At the same time you’re compounding risk, over-diversification can dilute returns, because if you have too many investments, the positive contribution of one won’t be big enough to have an impact. If a fund makes up only 1 or 2 percent of your holdings, for example, even a significant gain in that investment won’t sway the overall portfolio. “You’re increasing the odds of getting less-than-average performance,” Candura said.

In addition, if you have too much of the same asset class, you unintentionally risk “index hugging,” the term for when your holdings mirror a standard index, such as the Standard & Poor's 500. In that case, your return will revert to the mean, or average. But because the portfolio might not be balanced to match the index, it could actually lead to lower returns.

Furthermore, overall performance can be eroded by unforeseen trading costs, tax inefficiencies, or operating expenses. Paying for trades or sales charges in actively managed funds can add up, and high turnover in a taxable portfolio can create an expensive tax bill at the end of the year.

And an over-diversified portfolio can be too unwieldy to monitor, leading to “analysis paralysis.” “There are too many elements to track,” Adamson said. “Investors just get overwhelmed.”

Signs of portfolio bloat–and what to do about it

“There’s no flashing light” to indicate an over-diversified portfolio, Philips says. “It’s up to the individual investor to do a deep dive,” he continued.

How can you tell if you’ve got too much of a good thing? Morningstar has a free tool that instantly analyzes your portfolio and highlights sensitive sectors that show overweighting.

To see where funds overlap, go online to look up each fund’s description of its investment strategy. Is it focused on U.S. large-cap growth stocks or foreign developed markets? If the description of one fund’s strategy sounds similar to that of another, alarm bells should starting ringing. You can dig deeper by checking each fund’s top 10 holdings for duplication. “If you see Apple or Google in too many top 10 holdings,” Philips said, “you might question whether you bought the same thing five or 10 times.”

When there’s overlap, many experts advise choosing an index fund. “I don’t know of a stock index that doesn’t consist of hundreds, if not thousands, of stocks,” Yeske said. “That’s one way of being assured of broad diversification within the asset class.” And the operating expenses of an index fund are extremely low. Yeske says that the average charge of all the equity funds in the Morningstar database is about 1.3 percent, about 20 times more expensive than an index tracker. “You just can’t do better than index funds,” he said. 

Other financial mistakes to avoid

Editor's Note:

This article also appeared in the June issue of Consumer Reports Money Adviser.



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