Diversification has been touted by financial pros as a means of spreading out your risk. But can you be overdiversified? Here’s what you should know about overdiversification and rebalancing.
Rebalancing your portfolio may occasionally be necessary to realign its allocations to match your investment goals
Maintaining a diversified portfolio may require rebalancing when the economic environment changes
Ironically, too much diversification may result in underdiversification
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.
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.
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.
Asset allocation and diversification do not eliminate the risk of experiencing investment losses.
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.
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.
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