Over diversification is a serious and common mistake made by investors. Many investors have learned the harmful effects of under diversification and mistakenly believe that the more diversification the better. In portfolio management this concept is totally false.
What is Over Diversification?
Over diversification occurs when the number of individual investments in a portfolio exceeds the point where adding an investment asset does not reduce the risk of the portfolio more than the loss of potential returns.
When adding individual investments to a portfolio, each additional investment lowers risk but also lowers the potential return. Let’s look at two extremes; owning 1 stock or 1000 stocks. If you own just one stock your potential gain is very high but so is your risk. Your entire portfolio performance would ride on that one stock.
Each time an investment is added to the portfolio it lowers the risk of the portfolio, but by a smaller and smaller amount. In addition each additional investment also lowers the potential return. At some point you reach the number of investments where the marginal benefit of risk reduction is smaller than the loss of potential gains. If you own 1000 stocks you will have eliminated specific or unsystematic risk but your portfolio will not own the highest quality or best stocks.
Optimal or Proper Diversification
Most experts believe a portfolio diversification strategy having between 15 and 25 different assets is optimal to diversify away unsystematic risk. Of course proper diversification would require these assets be spread among several different industries. The point is you might be better off owning 25 quality stocks among a variety of industries than own 50 quality stocks and 950 mediocre stocks that pull your portfolio performance down.
Most investors have experienced the poor results of over diversification. Many institutional vehicles (i.e. diversified mutual funds, pension funds, equity index funds, etc.) are over diversified and therefore lack the ability to concentrate on quality instead of quantity.
The optimum portfolio diversification is to own a number of individual investments large enough to nearly eliminate unsystematic risk but small enough to concentrate on quality stocks.