Portfolio Rebalancing & Overdiversification: Can There Be Too Much of a Good Thing?

We know from practical experience that it’s possible to have too much of a good thing. When it comes to diversifying your portfolio, this piece of common wisdom may hold some relevance.

Adding a variety of stocks to your portfolio can help you capture a wider range of market opportunities while potentially reducing your overall market risk. But there’s a limit beyond which adding more stocks, no matter how diverse, might have a net-zero or negative effect on your portfolio.

This is called overdiversification, and it’s a mistake that investors can easily make, particularly when rebalancing their stock allocations. Let’s explore this concept, starting with the idea of rebalancing.

Why Rebalance Your Portfolio?

First, what does it mean to rebalance your portfolio, and why do it? Rebalancing a stock portfolio means changing the mix of stocks of which it’s comprised. It could mean reducing your stock holdings, adding more stocks, or replacing some stocks with others to help your portfolio stay in line with your financial goals and risk tolerance. In this article, we’ll focus on ways to maintain long-term diversification.

If you hold a diversified portfolio of stocks, the correlation among them may vary. As some stocks begin to underperform, hopefully some other stocks may outperform. But when a large segment of your portfolio begins outperforming or underperforming as a unit, it means those stock correlations may be a lot more concentrated (and less diversified) than you thought. This is when you might consider rebalancing your portfolio to recalibrate its level of diversification.

The tricky thing is that diversification isn’t a permanent or fixed state. You may start off with a well-balanced and diversified portfolio, but then the economic environment may change, disrupting your portfolio’s balance (as in the case of a secular bear market or recession). This can transform your once-diversified portfolio into a concentrated mass of assets that rises or falls in near-singular motion. A solution? It’s time to attempt to rediversify your holdings.

Caveat: As you attempt to rebalance your portfolio, be careful not to go overboard in your efforts. Too much diversification may end up either doing nothing or doing some harm to your portfolio’s overall balance.  

Diversification 101 (A Recap)

Why diversify? “When you buy a stock, you own the risk of that business, and your success as an investor is largely a function of that specific business and how it operates across various economic environments. In short, if that business succeeds, then you succeed,” said Viraj Desai, senior manager, portfolio construction at TD Ameritrade Investment Management, LLC.

So how might a long-term investor approach portfolio rebalancing with an eye toward adequate diversification? Desai suggested focusing on three dimensions of equities exposure.

1. Diversifying within and across sectors Diversifying within a sector means owning stocks that represent different industries within a given sector. As Desai explained, “Suppose you start with a blue-chip financial stock. Then you add another financial stock to incrementally diversify across business or industry risk. If you continue to add different stocks within that sector, you may eventually approach the overall performance of that sector.”At that point, what might you do next? Continue buying financials, which may no longer offer additional diversification benefits (a case of overdiversification)? “The answer would be to look elsewhere, toward other sectors, so that you avoid becoming overdiversified within one sector,” Desai explained. In short, diversifying across sectors might be a prudent and common-sense move if diversification is your goal. 
2. Diversifying across market capitalization Another area of diversification to consider is market capitalization (market cap). If you own large-cap stocks, typically shares of more mature or established companies, you may want to consider diversifying into small caps, such as those in the Russell 2000 Index.Why small caps? Small caps represent newer or smaller companies, so they tend to have more upside growth potential (but also more risk) than their mature large-cap counterparts.On another note, if your portfolio is already diversified across sectors, you may want to check its balance of small- to large-cap stocks to see if you're adequately diversified or overconcentrated in any of your market cap holdings.
3. Diversifying by country If you’re adequately diversified across all major U.S. equity sectors and market caps, then adding more U.S. stocks to the mix might have no effect or a negative effect on your portfolio’s diversification. This is where you might want to consider global equities. But be cautious, warned Desai: “Global equities are still going to be subject to macroeconomic risk. Your aim here is not necessarily to manage volatility but to diversify your return sources.”

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.

Overdiversification: That’s an Actual Thing?

It might be a good idea to diversify a portfolio so that you don’t stake all your prospects for success on just one business or one narrow segment of the economy. As Desai pointed out, you can diversify with just 20 stocks or even fewer. After that point, adding more stocks to the mix may not add to the overall diversification. The result could be negligible or, in some cases, could actually hinder the overall performance of the portfolio.

Portfolio overdiversification is a condition in which the potential benefits of diversification are exceeded by the risk of loss as a direct result of incrementally adding more securities. When you’re overdiversified, your exposures are more weighted or concentrated toward a given market segment. According to Desai: “Think of it as a spectrum, from the most concentrated to the most diversified exposures. Once you feel you’ve diversified your return sources, overdiversification means that adding an incremental stock may not materially enhance your portfolio.” 

Adding to an already diversified portfolio may actually result in greater concentration, reversing your direction in the spectrum. Ironically, the more overdiversified your portfolio gets, the more “underdiversified” it may become.

The Bottom Line

Rebalancing your portfolio to reestablish diversification can feel a bit slippery. It’s about finding that sweet spot in the spectrum, and it isn’t easy to do. But if you use the three equity dimensions of sector, market cap, and country to inform and guide your efforts, then you might be able to strike a fine balance without tipping the scale toward a less favorable result.