Is Your Investment Portfolio Too Diverse?

One of the first lessons that newbie investors pick up from their mentors is to diversify their investment portfolio. A portfolio is said to be diversified if it has a collection of stocks and investments that are spread across industries that are not related to each other. This is done to reduce the inherent risks that come with holding only one type of stock or holding on to stocks from the same industry. 

Once you put all your eggs in one basket, so to speak, there’s a greater chance that you’ll experience higher levels of volatility and permanent loss in case the company or industry that you put your money in suffers a setback. If your investment portfolio consists of cryptocurrencies, stocks, and real estate, for example, then there’s a better chance that you’ll bounce back in case the market for one of these assets experiences prolonged price declines. 

The Downsides of Diversification

Take note, however, that the stability one achieves through diversification comes with its own set of disadvantages. For one, spreading out your investments too much can lead to over-diversification. Simply put, over-diversification can take place when you own too many different kinds of assets to the point that outperforming their benchmarks or indexes becomes a significant challenge. If the incremental addition of an asset to a portfolio lowers the expected return more than the associated risk profile, then the addition of a wide variety of assets to a portfolio can do more harm than good. 

Let’s say you’re interested in adding cryptocurrencies to your portfolio but you want to mitigate the high level of volatility that comes with investing in this type of asset. Instead of putting your money on a wide range of cryptocurrencies and risking over-diversification, perhaps it’s a better move to carefully consider the coins that you’ll be purchasing and select the few that make it past your scrutiny. If you think privacy-oriented currencies are the future of crypto, for example, then it would be better to hold on to a few XMR coins in your Monero wallet instead of distributing your investment money to a bunch of cryptocurrencies for the sake of diversification.  

Is Your Investment Portfolio Over-diversified? 

Determining whether your portfolio is over-diversified or not can be a difficult task, as there’s no standard number where you can draw the line between diversified and over-diversified. According to experts, a diversified portfolio can have as few as 20 different types of assets. At the same time, there is minimal difference in terms of diversification and risk reduction for investors who own between 20 and 1,000 stocks. Instead of banking on a number to determine if your portfolio is over-diversified, it’s better to think whether or not you are spreading your investments too thin. 

It’s good practice to think about the assets in your portfolio and analyze if you put your money on that particular item primarily because you want to diversify. For example, hedging your bets on alcohol and tobacco companies may be against your personal principles, but you did just that because you want to have a more balanced portfolio. 

Or perhaps you’re incorporating cryptocurrencies into your portfolio and you invested a small sum on a few coins even though you really believe that only 1 or 2 of them will serve a meaningful purpose in the future. Now, instead of putting your money on a wide variety of assets that you don’t feel especially committed to, wouldn’t it be better if you concentrate your investment fund on assets that align with your investment principles and objectives in the first place?

How Do You Avoid Over-diversification? 

Keeping your asset portfolio at a manageable level is the best way to avoid over-diversification. For some investors, this means ensuring that their funds are allocated to the top 10 or 20 assets in which they feel the highest level of conviction. If you’ve already collected a wide range of assets to the point that you find it difficult to manage your portfolio well, then it’s a great idea to do a bit of cleanup. You can start by trimming investments in certain classes that are highly volatile or those that don’t align with your areas of interest. Having a keen understanding of the assets you’re holding and selling is a great way to ensure that your portfolio will remain at a manageable level. 

Diversify to Your Advantage

Too much diversification can have a negative impact on your portfolio, so consider carefully before you add an asset to your collection. Once you have a better understanding of the markets that you have interests in and align with your investment principles and objectives, you’ll have an easier time selecting the assets that really matter to you. This, in turn, will help you make the most of your diversification efforts and maximize the profits from your investment opportunities.

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