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Balancing Diversification and Dilution

Can you be too diversified in investing? Here are the red flags to look for, plus tips to help avoid dilution in your portfolio.

Insights from Motley Fool Asset Management Friday, June 07, 2024

read time 4 min read

Key Takeaways

  • Diversification is an important investing strategy.
  • Too much diversification can potentially weaken your portfolio and increase your risk.
  • Understanding your funds’ underlying holdings may help you avoid the risk of dilution.

When it comes to your money, you’ve likely heard the old adage, “Don’t put all your eggs in one basket,” right? It’s the practice of spreading your investments across different asset types, sectors, and products with the goal of minimizing risk and reaping the potential rewards of multiple opportunities.

Diversification is a foundational concept of investing, but that doesn’t necessarily mean that more diversification is always better. Being too diversified can be risky too. You may dilute the returns of high-performing stocks, paying more fees than necessary, and otherwise diminishing the growth potential of your portfolio. 

So, how do you build a balanced portfolio without diluting your investments? Let’s explore why diversification is so important, how dilution can jeopardize your long-term investing goals, and where to draw the line.

The importance of diversification

Diversification, at its core, is meant to mitigate the impact one stock or sector’s poor performance has on your entire portfolio.

Imagine if you had every penny of your portfolio invested in a singular high-performing tech company. While its stock is doing great today, what happens if they shut their doors next week? Because you’re concentrated in that one specific stock, your portfolio’s balance could drop down to $0. 

If your portfolio is diversified, on the other hand, you’d hopefully still be able to capture returns from your other investments — despite one company’s poor performance.

This may be an extreme (and unrealistic) example of an over-concentrated portfolio, but it’s easier to become over-concentrated than many people realize.

Suppose you earn equity compensation from your employer. In that case, you may find yourself with too much concentration in company stock — this is especially true for those who don’t or can’t proactively manage their vesting schedule. As another example, some experts argue that if your portfolio only includes domestic stocks (meaning you don’t hold international stocks), you could still be over-concentrated.

Too much of a good thing

The general consensus across the investment landscape is that diversification is a good thing. So how is it possible to have too much of it?

Let’s explore that question using the same example as before.

Say you’re invested in that high-performing, unicorn-esque tech stock — and it’s consistently on the up and up. As an investor, you should be benefitting from such positive stock performance. But… there’s a snag. You’re invested in many, many other investment vehicles (dozens upon dozens of stocks, or lots of mutual funds, index funds, and ETFs), so this particular stock only makes up perhaps 1% of your holdings.

You’ve put too many eggs in too many baskets — essentially diluting your returns from any one stock. As a result, your portfolio isn’t reflecting that positive performance, because it accounts for too small a percentage of your entire collection of investments. 

The risks of dilution

Aside from diluting your returns, there are a few other notable risks to over-diversifying your portfolio. These include:

#1: You’re over-concentrated in similar investments

It sounds counterintuitive, but over-diversifying can actually lead to over-concentration. How? Because when you diversify across vehicles like ETFs and mutual funds, you could unknowingly hold multiple shares of the same underlying stocks. If you buy various small-cap funds, for example, you’re likely over-concentrating your portfolio in one particular cap size — potentially holding shares in the same small-cap stocks over and over again.

#2: You’re overpaying in fees

If you’re diversified across many different investments, it’s important to track what management fees or trading costs you’re incurring. You may be spending a lot more than you need to, especially if your holdings are diluting your returns. 

Similarly, if you’re trading numerous individual stocks in a taxable portfolio, you could be hit with an unexpectedly high (and complicated) tax bill at the end of the year.

#3: It becomes too hard to monitor

Simply put, your portfolio can become unwieldy — too unwieldy to manage effectively. Rather than regularly monitoring and reassessing the effectiveness of your portfolio, the sheer number of things to track and consider can make you feel overwhelmed and anxious — to the point where you neglect to take action at all. Unfortunately, portfolios need at least a little bit of attention. Even those people who invest passively still want to monitor their portfolio performance and make small adjustments as necessary, based on their long-term goals and market changes. 

When you’re investing in too many funds, the sheer volume of investments can also make it more difficult to recognize when your portfolio is over-concentrated in one particular asset type or sector. If you can’t see the problem, you can’t fix it.

How to help avoid diluting your portfolio

Here are three steps you can take to help avoid dilution:

#1: Look at your funds’ underlying investments

If you own index funds, you should look at which underlying investments those funds hold – and how many. Many funds own several hundred stocks. Some funds, like many target-date funds, invest in other funds. You can own a handful of ETFs and still face the problem of winners not making a big difference to your portfolio.

Reviewing your funds’ underlying investments can also help you avoid the over-concentration that can come from over-diversification, because different funds from different investment managers can include the same stocks over and over again. And if several of your index funds are heavily weighted in mega stocks, you might be even MORE dependent on just a few companies. 

#2: Understand what you’re holding

When you over-diversify your portfolio with many different ETFs, mutual funds, individual stocks, bonds, alternative investments, and more… it’s possible you may accumulate certain assets you don’t understand.

Alternative investments, like private equity or hedge funds, may be measured using complex valuation methods, boasting greater return potential and more diversification than they actually have.

Knowing exactly what you’re investing in can help you avoid spreading your capital too thin across too many investment types. It can also enable you to better evaluate your holdings and make informed, strategic decisions that align with your goals and risk tolerance.

#3: Streamline your ETFs

ETFs offer investors numerous advantages, including low operating costs, greater general tax efficiency (as compared to mutual funds), flexible trading options, and more. There are good reasons why people invest in them.

But, instead of buying ETFs that overlap one another or provide you with so many underlying investments that none of them will ultimately matter, we suggest you streamline your ETFs to focus on a small handful that, as a group, provide diversification without significant overlap. That means paying attention to both the individual holdings and the number of holdings across those ETFs.

Finding the sweet spot

There isn’t a one-size-fits-all solution to achieve a perfect level of diversification. Every investor has different needs, and some can take on more risks than others. Your career stage, risk appetite and tolerance, preferred investing style, and financial goals should be taken into account too. However, these big-picture tips can help guide your journey as your dial in the unique blend for you and your wallet.

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