Over-diversification
by Gerald Townsend, Financial Editor

The concept of diversifying your assets is well accepted by investment professionals and the public as a way to reduce the risk of investing. The old adage of “Don’t keep all your eggs in one basket” is a universal truth and definitely should be applied when designing your investment portfolio. You can even find evidence of diversification in the Bible, as we are reminded in Ecclesiastes 11:2 to “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.”

However, sometimes it is good to challenge conventional wisdom, so let’s consider—is it possible to be over-diversified?

The Morningstar mutual fund database lists over 12,000 U.S. equity funds and on average, these funds own over 150 stocks each. The fund with the greatest number of stocks owned is an index fund that tracks the “total market” and owns 3,736 different stocks. Therefore, an investor owning eight or ten different mutual funds might effectively own small percentages of 1,000 different companies. Is this good or not?

Some believe that you can never be “too diversified”, and therefore by owning more stocks, either directly or through mutual funds, your risk is reduced. In one sense this is true, as additional holdings do provide added protection against the risk of a specific company or mutual fund having trouble. However, after a certain point, diversification really does not continue to provide significant protection against general market risk. If the overall investment market suffers a decline, the odds are your portfolio will also go down, whether you own ten stocks or two thousand stocks.

Mark Twain made an interesting counterpoint to the above adage when he said “Put all your eggs in one basket - and watch that basket!” Owning fewer, rather than more investments, and spending your time carefully monitoring these investments may prove to be a more rewarding experience than spreading yourself out over too many different ones. Great wealth is accumulated through concentration, rather than diversification. However, wealth is preserved by adequate diversification.

How much diversification is needed? A well-chosen portfolio of perhaps 20 – 25 stocks eliminates most of the business risk that would otherwise be present if you invested in only one stock. Keep in mind that this does not eliminate the general market risk that discussed above.

How do you build a concentrated portfolio that still provides adequate diversification?

You begin by choosing stocks from the major sectors/industries in the economy such as financial, technology, health-care, industrial, consumer staples, etc. An example of how not to do this would be to own ten different financial stocks and ten different technology stocks. In that case, you would have diversified yourself among companies, but not among sectors/industries.

If you are an investor in mutual funds, you can reduce your risk of over-diversification by owning at least some funds that invest in perhaps 20-30 stocks, as opposed to 200 stocks. There are a number of “non-diversified” funds that keep their portfolios small and tight. You would still want to own several different funds, in order to participate in different market areas, for example, small companies, larger companies, and foreign companies.

A well-known and successful “concentrated” investor is Warren Buffet. Consider this quote from one of the Annual Reports of Buffet’s Berkshire Hathaway:

“John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F.C. Scott, on August 15, 1934, that says it all: ‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence….’ “

Gerald A. Townsend, CPA/PFS,CFP®,CFA® is President of Townsend Asset Management Corp, a registered investment advisory firm in Raleigh, NC. His email address is Gerald@AssetMgr.com.