Disadvantages of Diversification in Investing

by KenFaulkenberry

in Portfolio Management

Disadvantages of Diversification in Investing

Disadvantages of Diversification in Investing

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.

3. Indexing

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).

Proper Diversification

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.

Related Reading: Investing Principles Fundamental to Successful Outcomes


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 3 comments }

Ted Ortiz

The advantage of this portfolio is the ability to get almost exactly the exposure you want to each narrow piece of the market while still enjoying the diversification that ETFs offer over individual stocks and bonds. The disadvantages are complexity and trading costs. With so many ETFs in the portfolio, it’s important to be able to keep track of what you own at all times. You could easily lose sight of your total allocation to stocks if you hold 13 different stock ETFs instead of one or even five. In addition, with so many ETFs in the portfolio and relatively more buying and selling, trading commissions could add up quickly. Whether you’re looking for super simplicity, extremely fine allocations or something in between, you can build such a portfolio out of ETFs.

Tonya E. Bullock

For the more adventurous investor who is not satisfied with the lower returns of mutual or index funds, picking individual stocks for a personal portfolio is the favored choice. Purchasing individual stocks can be done directly through any brokerage, with the only fees being the commission paid upon the purchase of shares and the capital gains tax paid upon sale. Investors define exactly the amount of shares to purchase, and the desired price. Dividends from individual stocks can also be reinvested into the company, with the same aforementioned advantages of mutual funds – dollar cost averaging and sidestepping the capital gains tax.

Tabatha Berger

Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio’s diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

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