- Date : 28/03/2022
- Read: 4 mins
Since the beginning, all investors have heard of the saying, "Never put all your eggs in one basket". This is nothing but a call for diversification. But is too much diversification good or bad for your portfolio?
Since the beginning, all investors have heard of the saying, "Never put all your eggs in one basket," which has come to be synonymous with "diversification." You're taught that diversification is the most effective method of minimising risk, as owning several non-correlated assets is less risky than owning just one or a couple. In practical terms, diversification is the realisation that you aren't sure which investments will outperform other investments at any time. Therefore, by mixing these funds, you'll be able to reap the benefits regardless of when and where they occur while smoothing out the volatility of your portfolio.
However, how much is too much? Is that even an issue?
In investing, the simplest answer is "It depends." You must consider factors such as your investment goals and risk tolerance, the type of investments you prefer, your time period, market conditions, and your ability to manage your investments. If you're a non-traditional investor and are more worried about risky portfolios, you might consider investing in an index-based fund. This can provide wide diversification and assurance. But the returns you earn will be limited by the return produced by the index. Index returns are not necessarily bad, and Warren Buffett openly recommends investing in index funds.
Creating your own portfolio
If you're looking to earn more than that of the market, then you should create an individual portfolio. However, you might be unable to attain this kind of broad diversification. Why do you think that? In reality, having excessive stocks could affect your portfolio, causing you to incur expenses but not necessarily decrease the risk.
Reductions in size, but no additional risk reduction
In addition to limiting returns, over-diversification may also reduce risk without presenting any apparent advantage. Each time you add a stock to your portfolio, you decrease the risk profile of your portfolio. However, adding more stocks may also lower the expected returns of your portfolio. In the end, you'll reach the point at which you have stocks in which the benefits in terms of risk mitigation are not significant, and your expectations of returns diminish. Thus, adding more stocks in that situation is just a way to diversify for the sake of diversification, which does not sound sensible.
How many stocks are needed for maximum diversification?
Numerous studies have attempted to establish the level where the increase in stocks results in lower returns, both in terms of risk reduction as well as reduced returns. Naturally, choosing the best number of stocks for an investor is contingent on the person's investing style and goals. A more aggressive approach requires smaller shares (closer to 10) as well as a more prudent approach requires higher stocks (30 and more).
You must know what you have
There's a more sensible reason not to do too much diversification. A large number of stocks in your portfolio can reduce the value of your investment portfolio. There are a limited number of top-quality companies available for purchase at a reasonable price at any moment. The process of researching, selecting, and tracking 20-30 top-quality companies is simpler than 50-100. It's much simpler to get an edge with smaller amounts of stocks you are familiar with. If you begin adding stocks for the sake of diversification, you'll end up losing quality, which can put your portfolio at more risk. It is important to attain enough diversification but still be able to understand the reasons behind every stock within your portfolio.
Be aware that it's nearly impossible to protect yourself from systematic risks, also known as market risk. When macro-events go wrong such as recessions, changes to interest rates, or an economic collapse, stocks are involved in spreading market forces. There's not much you can do to stop it, and trying to anticipate the market's reaction to the events can be a futile task.
It's important to invest in the top-quality firms in your portfolio because their strong balance sheets, as well as their ability to sustain cash flow, allow them to maintain their success during even the most difficult times. Thus, diversify your portfolio as per your needs and avoid over-diversification. The basic thing is that the cost/time of diversification should be less than the benefits of diversification.