Forbes – The Diminishing Benefits Of Too Much Stock Diversification

From early on, most investors have heard the adage, “Never put your eggs in one basket,” which has become synonymous with the term “diversification.” They’re taught diversification is the key to minimizing risk because owning many non-correlating assets is less risky than owning one or a few. Practically, diversification is the recognition that you can’t know which investments will outperform others at any given time. So, by combining these assets, you should be able to capture returns whenever and wherever they occur while smoothing out portfolio volatility.

But how much diversification is too much diversification? Should that even be a concern?

As so often in the realm of investing, the short answer is, “It depends.” You have to consider such factors as your investment objectives, risk tolerance, investment preferences, time horizon, market conditions and your ability to manage your holdings. If you are a hands-off investor and more concerned about portfolio volatility, you may do well to invest in an index fund that would provide you with broad diversification and some peace of mind. But your returns will be limited to the returns generated by the index, which is not necessarily a bad thing.

If you want the opportunity to achieve returns greater than the market, you can create your own portfolio. However, you may find it challenging to achieve that kind of broad diversification. But why would you? In fact, owning too many stocks can be detrimental to your portfolio, increasing your costs while not necessarily reducing your risk.

Smaller Returns With No Additional Risk Reduction

“Over-diversification” can limit returns with no perceivable advantage of further risk reduction. With every stock you add to your portfolio, you lower its risk profile. At the same time, the incremental addition of stocks can also reduce your portfolio’s expected returns. At some point, you reach the number of stocks where the benefit of risk reduction is negligible, and your expected returns are diminished. So, adding additional stocks at that point is diversification for the sake of diversification, which doesn’t make sense.

How Many Stocks For Optimum Diversification?

Various studies have tried to determine the point at which adding more stocks produces diminishing returns, both in terms of additional risk reduction and reduced expected returns. Benjamin Graham, “the father of financial analysis,” put the number between 10 and 30. In a study by Frank Reilly and Keith Brown, they found that portfolios containing 12 to 18 stocks provide about 90% of the maximum benefit of diversification. Of course, the right number of stocks for an investor also depends on the individual’s investment style and objectives, with a more aggressive approach requiring fewer stocks (closer to 10) and a more conservative approach requiring more stocks (30 or more).

You Need to Know What You Own

There’s an even more practical reason to avoid too much diversification. Owning too many stocks can compromise the quality of your portfolio. There are only so many high-quality companies out there that can be purchased at a fair price at any given time. Finding, researching, selecting and tracking 20 to 30 quality companies is far more manageable than 50 to 100. It’s much easier to gain an advantage when you own fewer stocks that you know well. If you start adding stocks just for the sake of more diversification, you are likely sacrificing quality, which can expose your portfolio to greater risk. The objective should be to achieve enough diversification and still be able to understand why you’re invested in each of the stocks in your portfolio.

For Best Diversification, Focus On Quality

Keep in mind that it is nearly impossible to diversify away systematic risk, also referred to as market risk. When adverse macro-events occur, such as a recession, changes in interest rates or a market crash, stocks get caught up in the contagion of stock market forces. There’s little you can do about it, and trying to time the markets around these events is a fool’s errand.

That’s why it’s so important to own the highest-quality companies in your portfolio because their strong balance sheets and enduring capacity to generate cash flow enable them to perform well in the worst of circumstances. While their stocks may fall in a severe market decline, they are typically among the first to recover when the market bounces back. Plus, large companies with solid brands, broad global reach and dominant market positions tend to be well-diversified in and of themselves, which provides another layer of diversification.