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The Dangers of Overdiversification

By Charles L. Norton, CFA
Special to RealMoney.com
6/28/2004 10:59 AM EDT

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."
-- Warren Buffett

One generally accepted principle is that prudent investors should always diversify. According to this theory, if you have a lot of stocks in your portfolio, you're spreading your risk across many positions. By doing so, you reduce the risk of any single stock having a negative impact on your overall returns.

This may be true, but too much diversification can also lead to mediocre returns. Your portfolio could end up closely following the market. In other words, you're "closet indexing."

Without getting too deep into the academia, diversification does have benefits -- and limits -- in reducing risk. Total risk in a portfolio can be broken down into two components:

1. Market-related risk, which is attributable to broader-market movements that may be caused by macroeconomic variables that affect all risky assets.
   
2. Non-market-related risk, which is company-specific risk for a single investment.

As the chart below shows, a well-diversified portfolio can reduce almost all of the non-market-related risk. That leaves your portfolio with only market-related risk, which can never be diversified away.

Total Risk for an Investment Portfolio as a Function of the Number of Stocks

Source: GNI Capital

Studies have found that it takes only 15 to 20 randomly selected stocks to diversify a portfolio adequately to the point where there's little non-market-related risk. Beyond that point, adding more securities doesn't help to reduce the total risk in the portfolio. Therefore, the returns on a heavily diversified portfolio -- without company-specific risk -- are essentially mirroring the returns of the market.

Overdiversifying also has a few other disadvantages. First, it's very difficult to know several dozen companies inside and out. When you try to spread out your risk into many companies, you're also often thinning out your knowledge about each of the companies in your portfolio. If you're unable to monitor all of your positions, you're more likely to get weeds in the garden, letting some losers stay in the portfolio longer than they should. Limiting the number of stocks in your account will help ensure that your time is dedicated to staying on top of all your positions.

Another problem is the lack of flexibility when the market turns and you decide to raise cash. Selling one or two stocks in a 100-stock portfolio won't do much at all to reduce your exposure. A more concentrated portfolio allows you to be more nimble: If you only own, say, five stocks, selling one gives you 20% cash in a snap.

Worth the Effort?

So why would investors go to great lengths to pick out their best 100 ideas if their returns are unlikely to differ much from the market? Where's the added value?

The appeal of broad diversification stems from the erroneous belief that successful stock-picking is rare and as a result, few people can beat the market over the long term. If that were true, then well-diversified portfolios should perform almost the same as concentrated portfolios, but with substantially less risk.

A recent study conducted by two University of Michigan finance professors, Clemens Sialm and Lu Zheng, and one of their graduate students, Marcin Kacperczyk, attempted to test this claim. The researchers worked with the performance of 1,800 funds, measured over a 16-year period. They concluded that mutual funds that were more concentrated outperformed broadly diversified funds. In fact, the least diversified 10% of funds performed nearly 2 percentage points a year better than the most diversified 10%. In other words -- surprise, surprise -- managers can indeed add value with stock-picking and concentrated portfolios.

Other Ways to Spread the Risk Around

Diversification may be appropriate for certain investors, but buying exchange-traded funds, or ETFs, may be a better approach. Depending on which one you buy, you can own a diversified portfolio with only one transaction -- without having to try to focus on every company in the portfolio. Also, because ETFs trade throughout the day, it's very easy to adjust your exposure and raise cash quickly when needed.

Another idea is to diversify across time. Let's say your first purchase in a new stock idea is 50% of the size of your typical full position. When the stock moves up from your purchase price, the market is basically confirming that you're right, so you buy another 30%, bringing your position to 80% of what you'd consider a full position. Over time, the stock keeps rising, and you round out your position with a final buy of 20%.

By spreading out your buys, you're diversifying across time. This way, you are only building up positions that are going your way, which will end up being your larger holdings; the stocks not doing as well will only be partial positions.

Remember that non-market-related risk in the chart above that many investors try so hard to eliminate by adding more and more stocks? Well, you get paid to bear that company-specific risk, which will directly impact your return when done judiciously in the right circumstances. Carefully analyzing and prudently accepting risk when it is priced correctly will help you keep your eye on the ball -- producing superior returns.