Disadvantages of over diversification

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In the last post what is diversification, we gave a glimpse of diversification and a simple example to understand how it reduces the risk. In this topic we cover the disadvantages of over diversification mainly by considering the stocks. As of now I am not touching diversification across asset classes. To start with, when anybody thinks of diversification, probably the first question in his mind would be, how much I should diversify?. The best answer would be ‘not much’. Please look at below graph to understand further. Image courtesy : thismatter.com/money In the above figure, there are two risks explained. One is Systematic risk: this is also called as market risk. It implies, when the market sentiment is negative, your security prices may drop, however good your stock may be. In those scenarios, your diversification strategy doesn’t work. If you invested in 10 stocks, the chance is that all your 10 stock prices may come down along with the market.

Second is diversifiable risk: yes, this risk can be greatly reduced with good diversification. Why I mentioned ‘good’ diversification is, say if you have invested in 10 different companies then of course you may feel that you have diversified your portfolio. May be, but that is not ‘good diversification. A ‘good’ diversification example is, say you have invested in 10 companies and those 10 companies are from different sectors. What more, those sectors are low correlated. And further, those are from different countries. Yes, that can only be considered as ‘good’ diversification. With the above figure we can understand that risk can be reduced to a certain extent with diversification but can’t nullify. Second & most important point is, there is really no advantage of extending your portfolio to more than 20 to 25 stocks. And managing over diversified portfolio is hard and costs more. By concentrating more on diversification, you may lose the opportunity of putting your efforts and investment on winning stocks (1 or 2 out of your 20 plus stocks) !! We are concluding this topic with Warren buffet’s quote "wide diversification is only required when investors do not understand what they are doing"

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Mohan Bhupathiraju

Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.