Diversification is a key investing principle, aimed at reducing your risk by spreading your investments across different assets, industry sectors, or markets. The key objective of diversification is that if one investment underperforms, other investments can help to balance out the losses. However, there is a point where diversification can go too far, and there is a risk that you can become ‘over-diversified’.
What is Over-diversification?
Overdiversification can occur when an investor holds too many assets or shares, almost for the sake of holding multiple assets, rather than their potential benefits. When a portfolio contains so many different investments, its performance can actually be affected in a negative way, as opposed to the positive benefits diversification aims to achieve.
The Downsides of Over-diversification
- Increased Costs: Managing a large number of investments is both difficult and costly.
- Diluted Performance: Holding too many assets can dilute the impact of strong performers, making it harder for the portfolio to generate significant returns.
- Complexity: Keeping track of numerous investments and their performance can be overwhelming.
A Real-Life Example: Georgia Harrison
I recently met with a new client who had invested approximately $175,000 in shares with the help of a financial planner. With these funds, the planner had spread their investments over 42 different managed funds, exchange traded funds and shares. Some of the investments were for as little as $500. The client liked the idea of diversification when it was presented but didn’t understand why there needed to be so many different parcels of funds/shares.
The Hidden Costs
The client hadn’t initially realized the costs associated with buying and selling such a wide range of investments, or how much each holding would need to grow to generate a profit. Spreading money across so many investments is neither economical nor beneficial. Each time you buy or sell a parcel of shares, you incur transaction costs, and with smaller holdings, the stock price would need to rise significantly just to cover those costs and yield a profit. Additionally, managing 42 different holdings makes it difficult to stay informed about each company’s performance and developments.
Streamlining for Success
As a financial adviser specialising in shares, I and iInvest were able to help the client streamline the portfolio to maintain diversification and yield, setting them up for success. The client now holds just eight parcels of shares, offering diversification across industries and markets, while minimizing costs and delivering the desired returns.
Planner or Adviser – What’s the Difference?
We often explain the difference between a financial planner and a financial adviser specialising in shares. The planner should do the “plan” across asset classes and the share specialist should “execute” this plan.
In practice, this means you consult a financial planner to discuss how much you have to invest, and they will recommend allocating specific amounts to property, super, shares, etc. For example, if they advise putting a certain amount into property, they typically don’t assist in selecting a specific property, that’s the role of a real estate agent. The same approach applies to shares, the planner creates the overall strategy, and then a specialist share adviser steps in to recommend the most suitable shares for the portfolio.
Finding the Right Balance
In essence, financial planners offer broad financial advice, and specialist share advisers focus on trading and share selection. While diversification is important – too much can hinder your gains, while not enough adds risk – it’s essential to strike the right balance for success.
DISCLAIMER: The information provided is of a general nature, for the recipient’s information only and has been prepared without considering any particular individual’s investment objectives, financial situation or particular needs (“relevant circumstances”). Before acting on this information, you should carefully consider the appropriateness of it having regard to your own relevant circumstances and if necessary, seek appropriate professional advice. We believe this information is correct at the time of its compilation however no warranty is made as to its accuracy, reliability, or completeness. We cannot guarantee the performance or return on investments and those acting on this information do so at their own risk.
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