Definition of Over-Diversification

Putting too few dollars into too many assets can hinder portfolio growth.

Putting too few dollars into too many assets can hinder portfolio growth.

Generally, diversifying your investment portfolio is a good thing. By owning a number of different products from a number of different categories, you are protecting yourself from a huge loss should a particular type of asset suddenly crash. The expression "too much of a good thing" can be applied to diversified portfolios, though, because over-diversification can cause problems just as easily as a lack of diversification.

Diversification

A person's investment holdings need a certain amount of diversification. This can mean investing in different vehicles, such as stocks, bonds and cash. It can also mean investing in different categories, such as growth-oriented mutual funds, balanced funds, and value-oriented funds. Proper asset allocation takes into account time until retirement, risk tolerance, and financial goals. A diverse portfolio may include "safe" investments, such as Treasury bills and money-market funds, to offset the risk of a stock market crash.

Over-Diversification

Just as a lack of diversification can be a problem, so, too, can too much diversification. An over-diversified portfolio is invested in so many different vehicles or so many different asset classes that, while there may no longer be a risk of any great losses, the portfolio owner or manager is limiting the possibility of any great gains. When there are too many investments, individual results are limited if one of them rises rapidly, because the asset represents only a small fraction of the portfolio.

The Problem

Proper portfolio diversification limits risk of loss without sacrificing potential gains, but over-diversification does actually sacrifice the latter in an unnecessary quest for the former. Spreading money too thin is simply not worthwhile -- the loss of potential gains more than offsets the added reduction in risk. One of the points of actively managing your investments is that you want to outdo the performance of passively managed ones, such as an index fund or retirement-year fund.

The Ideal

While every investor's perfect asset allocation is different, the important element in diversification is maximizing gains while minimizing losses. A good asset allocation for an individual stock investor may be 12 to 20 companies, with something like four or five being too few for prudence and more than 20 passing the tipping point for diminishing returns. Mutual funds may also fall victim to over-diversification. An October 2011 article in "Fiduciary News" cited a survey that found funds invested in 30 to 50 different stocks outperformed those with upward of 700 investments.

About the Author

Eric Strauss spent 12 years as a newspaper copy editor, eventually serving as a deputy business editor at "The Star-Ledger" in New Jersey before transitioning into academic communications. His byline has appeared in several newspapers and websites. Strauss holds a B.A. in creative writing/professional writing and recently earned an M.A. in English literature.

Photo Credits

  • Jupiterimages/liquidlibrary/Getty Images