Too much of a good thing: How to avoid over-diversifying

Diversification is an important way to manage risk and returns by spreading money among different investments. This includes diversifying within asset classes, such as Australian shares, and across asset classes, to include Australian shares, international shares and bonds.

Diversification and asset allocation can often be confused, but they're not the same thing.

You should consider your asset allocation first, starting with the percentage split between growth and defensive asset classes. A high-risk investor may have 90% allocated to growth assets, such as shares, and 10% to defensive assets, such as bonds, whereas a low-risk investor may have the opposite split. Then, diversify within the asset classes to get the optimal overall portfolio for your situation/goals.

But how many different investments do you need within an asset class to provide the benefits of diversification? Is it possible to over-diversify a portfolio?

You can have too much of a good thing

Here are the key risks with over-diversification.

Increased costs

If you're picking individual stocks, you'll pay transaction costs with each buy and sell, which can add up if you have a large number of holdings. Costs eat into returns more than most people appreciate and can quickly deplete your investment returns.

Excessive complexity

Diversification works well because of the varying characteristics of different investments, and the way that variation can smooth out returns and volatility over time. There is a law of diminishing returns after which the benefit becomes almost negligible.

You'll be increasing complexity without really getting the benefit of lower risk or targeted investment returns.

Unwieldy to manage

If you're managing your own portfolio of individual stocks (versus managed funds or ETFs), then the number of stocks you need to monitor can simply become too unwieldy and time-consuming.

It can also add unnecessary stress during times of extreme market volatility. And it's harder to rebalance this kind of portfolio, which means you're less likely to perform this important process.

So how much diversification is enough?

Let's focus on picking individual stocks first. Research suggests that within an asset class, owning 15-20 stocks provides a vast majority of the benefits of diversification (risk management for desired investment returns). This assumes the investments are equally weighted across those stocks. So owning 20 investments/stocks within an asset class gets you about the same benefit as owning 1000.

The exception to this rule of thumb might be in building a portion of your portfolio aimed at capturing exposure to the overall global share market, in which case more investments would probably be needed to diversify across such a vast expanse of regions.

So, have enough stocks to be well diversified, but don't feel the need to fill your investment basket with more shares than you can manage, unless there is a fairly simple, cost-effective way to do so. This is where ETFs enter the picture.

ETFs are listed index funds that track, you guessed it, an index, such as the ASX200, the S&P500 (US), a bond index, and much more. Because these funds are passive, in that they track and index rather than try to time the market or pick winners, they are low-cost and enable instant diversification with one trade.

Many of them are also issued and managed by highly reputable companies such as Vanguard, Blackrock, and State Street. If you want to pick individual stocks, that's fine, but it can be prudent to use ETFs to build around your individual stocks to minimise costs and enhance diversification.

Vanguard's global shares ETF excluding Australian shares, VGS, tracks a global share index that includes more than 1500 of the world's largest companies. So you can get broad exposure to such an asset class via one trade with VGS.

Four tips to remember

1. Get your asset allocation right first so you have a suitable risk dimension to your investments.

2. Remember to periodically rebalance your portfolio as asset class values move over time.

3. Stick to some of the basic rules above about diversification and the prudent use of ETFs to help you build a study portfolio that is more likely to perform well over time.

4. Consider getting some support to build and manage an affordable and well-diversified portfolio that's suitable for your risk appetite and time horizon.

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