Portfolio Lab: Avoid OverdiversificationJul 06, 2012
Everyone talks about diversification but hardly anyone mentions the tyranny of overdiversification.
Portfolio diversification has been a foundation of investment management for decades. The basic idea is to hold different types of investments within the same portfolio to avoid getting crushed if and when the market tanks. Diversification isn’t designed to prevent losses, but rather, to minimize them.
While most financial professionals advocate diversifying your investments, the problem of overdiversification is almost never discussed. What is it?
An overdiversified portfolio is one that holds too many of the same types of investments. Instead of owning a well-designed basket of various investments that complement each other, the investor who suffers from overdiversification ends up owning investments that appear different, but are essentially the same. What’s the end result? A portfolio with too much of the same thing.
Below is a snapshot of Portfolio X, which consists of just five holdings. Can you identify which holdings are overlapping? If you said ticker AGTHX, FCNTX, and QQQ – you’re right! Each of these investments, despite having different labels, own the same types of stocks; large cap growth companies. Owning these three investments within the same portfolio is a classic example of overdiversification.
SNAPSHOT: Portfolio X
20% - American Funds Growth Fund of America (Nasdaq: AGTHX)
20% - Fidelty Contrafund (Nasdaq: FCNTX)
20% - PowerShares QQQ (NasdaqGM: QQQ)
20% - iShares Barclays Aggregate Bond Fund (NYSEArca: AGG)
20% - Cash (Nasdaq: FRTXX)
Why is overdiversification a problem? Because it serves no real useful purpose and can actually increase a portfolio’s risk profile.
For portfolios that consist mostly of ETFs and mutual funds, overdiversification causes fund investors to double or triple pay investment fees for identical funds. Over time, these compounding costs eat and erode an investor’s returns.
ETFguide’s Portfolio Report Card is a written report that helps investors to identify strengths and weakness in their investment portfolios. The Report Card also tells you whether your investment portfolio has too much risk.
Over the past two years, I have used this grading system to evaluate listener portfolios on my weekly radio program, the Index Investing Show, and it works.
In summary, if you want to have success, avoiding an overdiversified portfolio is key.
Portfolio Lab is a new column from ETFguide that focuses on investment tools and ideas to help individual investors improve their bottom line results.