We rarely focus on the disadvantages of diversification in investing because we are taught the purpose of portfolio diversification is to lower portfolio risk. In fact a certain amount of diversification is crucial, otherwise you will be taking risk that you will not be compensated for.
However, some lessons can be over learned. Diversification done improperly, including over diversification, can be very harmful. Here are some investment diversification disadvantages:
Disadvantages of Diversification in Investing
1. Reduces Quality
There are only so many quality companies and even less that are priced at levels that provide a margin of safety. The more stocks you put into your portfolio the less concentrated your portfolio will be in the best opportunities.
2. Too Complicated
Many investors include so many assets in their portfolio they don’t really understand what’s in them. Diversification in investing is important, but keep your portfolio simple enough that you can stay on top of your investments.
If you have too many assets in your portfolio it essentially becomes an index fund. If you want an index fund, buy an index fund; don’t waste transaction fees on purchasing numerous assets that morph into an index fund.
The more stocks you own the more correlated your portfolio will be to market returns. While passive management or indexing might work in bull markets it does not work well in flat or bear markets. Most indices are skewed toward stocks that have already risen and underweight stocks that have fallen, and may be at bargain prices.
4. Market Risk
Before you buy an index fund be sure you understand how the mathematics of portfolio volatility lowers your portfolio performance. Few investors ever achieve even close to “average” returns because of volatility caused by market risk.
5. Below Average Returns
Indexing and over diversification are disadvantages of diversification because quality suffers when you own inferior investments along with good investments. Below average returns result from transaction fees or high mutual fund fees. In addition to portfolio volatility lowering returns, many investors let their emotions cause them to buy high and sell low.
6. Bad Investment Vehicles
Most investors who over diversify use investment vehicles such as index funds, or even worse, actively traded mutual funds. Actively managed mutual funds trade in and out of stocks and have a tendency to focus on short term trading instead of value. Studies show these funds underperform market indices in the long run.
7. Lack of Focus or Attention to Your Portfolio
If someone else is managing your portfolio you probably don’t pay as much attention to it, or you wait until it’s too late (i.e. after your quarterly statement arrives).
Allocate your money based on valuation and not some wall street manufactured formula. That may mean holding more cash when bargains are not available. When purchasing stocks stick to the highest quality companies priced at valuations that put the odds of success heavily in your favor.
You can avoid the disadvantages of diversification in investing by managing your own portfolio. Diversification is one of the most important concepts in investment portfolio management, but proper diversification is the key. While building your portfolio keep in mind the disadvantages of diversification in investing to help you achieve optimal diversification.
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