Why your retirement savings plan may be overdiversified

It's the time of year when your 401(k) plan administrators are showering you with annual disclosure statements. It's tempting to toss them, but before you do, check your portfolio to make sure you haven't fallen into the overdiversification trap.

Most financial advisors will tell you that diversification—spreading your money across several asset classes and investment styles—is the best way to protect your portfolio from risk and volatility. But what if an investor overdoes the advice not to put all her eggs in one basket and has too many eggs in too many baskets? Overdiversification—buying more and more mutual funds, index funds, or exchange-traded funds (ETFs)—can actually amplify risk, stunt returns, and increase transaction costs and taxes. 

Is your portfolio properly balanced? Read "Right-sizing your asset allocation" to find out. 

Too much of a good thing

Overdiversification is a situation that sneaks up on you—especially as you collect funds in your retirement accounts without considering the overall impact on your portfolio.  

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 four different 401(k)s, a Roth IRA and a regular IRA.  The client stated that he didn't want to invest in foreign stocks, yet after analyzing the funds in the portfolio, Adamson discovered that 30 percent of the fund holdings were in international equities—a huge overweighting. "He thought he was diversified because he had money in four different 401(k)s and two IRAs, instead of looking at his underlying investments," Adamson notes.

A bloated portfolio can negate the benefits of diversification in a variety of ways:

• Owning too many funds increases risk by concentrating your holdings in a few areas. A typical joke after the technology bubble burst was that investors thought they were diversified because they held Janus Twenty, Janus Mercury, and Janus Growth; in reality, each of those funds held almost the same technology stocks.
• Funds with completely different strategies can, in fact, hold large concentrations of the same stocks. For example, five of the top ten holdings of an index fund tracking the growth stocks in the S&P 500 (ticker: IVW) are also in the top ten picks of a well-regarded technology mutual fund (VGT).
• Returns suffer for the simple reason that if you have too many investments, the positive contribution of one won't be big enough to make a difference. For example, if a fund only makes up 1 or 2 percent of your holdings, even a significant gain in that investment won't sway the overall portfolio.  
• In addition, if you have too much of the same kind of asset class, such as large-cap stocks, you risk "index-hugging," the term for when your holdings mirror one of the standard indices, such as the S&P 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.
• Overall performance can also be eroded by unforeseen trading costs, tax inefficiencies, or, operating expenses. Paying for trades or sales charges in actively managed funds can add up; similarly, high turnover in a taxable portfolio can create an expensive tax bill at the end of the year.
• Last, an overdiversified portfolio can become too unwieldy to monitor, leading to what financial advisors call "analysis paralysis." "There are too many elements to keep track of," says Adamson. "Investors just get overwhelmed." 

Avoiding portfolio bloat

There's no flashing light that says, "I'm an overdiversified portfolio." It's up to the individual investor to take a deep dive.

• 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 eerily familiar to that of another fund, alarm bells should starting ringing.
• Check each fund's top ten holdings for duplication. If you see Apple or Google in too many top ten holdings, you might want to question whether you bought the same thing five or ten times.














Finding the right balance

• For novice investors, start with one low-cost fund that covers the total U.S. equity market or a target date fund that includes U.S. and international stocks and bonds.
•  It makes sense to diversify into specific asset classes when your portfolio reaches $10,000.
• Five to seven funds are sufficient. Divide them among: large-cap growth and large-cap value stocks (or both, through a large-cap blend); small-cap growth and small-cap value; international equities (including developed and emerging markets); and U.S. bonds.

— Catherine Fredman