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A well-diversified portfolio is often touted as a cornerstone of a strong long-term investment strategy. But can it ever be possible for your assets to be over-diversified?
Technically, no—there are always new opportunities for investors to explore to mitigate risk. However, due to limitations in time and resources to achieve the perfect blend of assets, it’s easy to go overboard with diversification in certain areas. You risk holding so many assets that unnecessary fees pile up, or you struggle to effectively manage your investments.
“The major danger of over-diversifying is that you burden yourself with too many investments to track, and the process of oversight becomes overwhelming,” says Christine Benz, Director of Personal Finance at Morningstar. “Moreover, your portfolio may resemble the broader market, but you’ll likely be paying a lot more for that portfolio than you would for a low-cost broad-market index fund or ETF.”
This last point is crucial. If you’re invested in low-cost, broad-market index funds—as Two Cents and most personal finance experts recommend for retirement savers—there’s no need to waste time, energy, or money researching and investing in funds that expose you to the same areas of the market. Essentially, you’re creating a kind of pseudo-diversification.
Research from Morningstar shows that “when faced with too many options, investors tend to spread their assets evenly across all choices, rather than selecting the most suitable investments based on their financial goals.” This type of naive diversification, as Morningstar refers to it, can actually harm your retirement savings. On average, it costs four times more for the same exposure that can be obtained with lower-cost funds, Morningstar found.
According to Cheryl Ober, a fee-only Certified Financial Planner, the average investor can achieve proper diversification by selecting one or two funds from an investment class. After that, there is no significant improvement in returns or reduction in risk.
“What people fail to realize is that when they invest in two or three large-cap growth funds, for instance, the industries or companies those funds invest in are often very similar. They are all typically investing in the same set of stocks,” says Ober. “Most funds within a specific category tend to be alike, as there are only so many stocks available for them to invest in.”
At that stage, you’ll be paying more for the same performance, just for the privilege of a different fund manager. And that’s not worth the cost.
This is why strategies like the three-fund portfolio have gained widespread popularity. They are simple and offer results that are as good as you can reasonably expect over the long haul. Such strategies can give you access to satisfactory returns with minimal complexity.
