Investor Beware: Why You Shouldn’t Over-Diversify Your Portfolio

Portfolio diversification is one of the most important concepts we learn as investors. Those who are properly diversified can significantly reduce the amount of risk that their portfolios take on. Even if we do the proper research on the stocks in our portfolios, unforeseen events could happen that could send a business or an entire industry off course. If your portfolio is overexposed to such an industry, then your portfolio would likely experience excessive volatility compared to a properly diversified portfolio of securities.

While many investors believe diversification is essential to long-term success, I believe diversification is actually more of a double-edged sword, which could hurt the average investor if they over-diversify, or “di-worsify” (a term coined by legendary investor Peter Lynch).

A beginner investor might think that if they buy a tonne of stocks across various industries and geographies, they’ll have a “safer” portfolio than average. However, this is simply not the case; in fact, diversifying to such extremes could actually be hurting your long-term investment goals.

First, if you own more than 20 stocks, you’d have an extremely difficult time keeping up with each one. There’s just not enough time in the day to keep up, and you’d be doing yourself a great disservice by biting off more than you can chew.

Second, you’d probably be better off with an index fund or an ETF like the S&P/TSX Composite Index (TSX:^OSPTX) or the iShares S&P 500 Index Fund CAD Hedged (TSX:XSP) if your goal is to achieve complete diversification. You’d definitely save on the commission fees if your portfolio has ballooned to an unmanageable size!

Third, the more stocks you have, and the more diversified your portfolio becomes, the more your portfolio becomes similar to the market. As a result, you’ll have a tougher time beating the market, and if that’s your goal (for many DIY investors, it is!), then you’d probably be better off with a more concentrated portfolio of the strongest businesses.

Lastly, no matter how diversified you make your portfolio, you’ll never be able to completely eliminate market-wide risks or systematic risks. I think 15 stocks should be the maximum that an investor should have in their portfolio. Any more than this probably won’t do you any favours; you’ll essentially be di-worsifying your portfolio with businesses you may not understand with great detail.

Bottom line

Diversification is an important concept to know as an investor, but it’s important that one understands both sides of the story. I believe diversification is one of the most overrated and most abused techniques of portfolio risk reduction.

It can reduce portfolio risk to an extent, but you could also significantly reduce your chances of beating the market in the long run in addition to wasting time and money through additional commission fees that come with managing an oversized portfolio.

Stay smart. Stay hungry. Stay Foolish.

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Fool contributor Joey Frenette has no position in any stocks mentioned.