Diversification: How Much Is Too Much?

‘Never put all your eggs in one basket’ may be the most well-known and commonly used financial advice out there. Nearly every wealth manager and financial planner starts off by explaining the benefits of diversification.

That’s because spreading out capital in different asset classes, geographies, and funds is the easiest way to mitigate risk and limit the downside. According to Modern Portfolio Theory (Ben McClure, Investopedia, Dec 12, 2017), a portfolio of uncorrelated stocks or bonds can eliminate the unsystematic risk, leaving the investor exposed only to systemic risk. In other words, a basket of stocks of companies from different industries will cancel out the individual risks of each company and leave the investor exposed only to the average risk of the market, which should be comparatively lower.

However, there is such a thing as too much diversification. In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis," they concluded that there was a limit to the risk mitigation benefits of diversification. Every new stock added to a portfolio would lower the overall risk down, but the risk could never be lowered than the average market’s risk (systemic risk). In other words, adding stocks beyond this point had diminishing returns and was a waste of effort.

So, how many stocks is too many? According to  Elton and Gruber's book, the first 20 stocks added to a portfolio reduced the vast majority of unsystematic risk. Stocks added beyond that point had a negligible impact on the overall risk the investor faced.

It’s important to note that these 20 stocks need to be highly uncorrelated. The stock prices of different companies need to move differently at different times. For example, energy companies may perform badly when the market price of crude oil plunges, but lower oil prices reduce the costs of airlines which might boost their stock. Holding stocks from both industries neutralizes the effect.

With this framework in mind, it’s easy to see how most investors over-diversify. Every new mutual fund or debt fund adds hundreds of securities from a wide range of different companies, sometimes spread across the world. This adds to the complexity of the portfolio without adding much value. Investors would be better served by striking the fine balance between diversification and overextension.

Warren Buffett, arguably one of the world’s best investors, also believes in striking this balance. “Diversification is a protection against ignorance," he once said. "[It] makes very little sense for those who know what they’re doing.”

For the average saver, it’s best to hire wealth managers or financial planners who “know what they’re doing.

The value of investments and income from them may go down as well as up and you may not get back the original amount invested.