Investors have heard the advice, “Don’t put all your eggs in one basket,” so many times it barely registers anymore. It seems so obvious that most of us accept it without a second thought. Diversify. Invest in non-correlated assets to help manage portfolio risk.
Diversification is an essential component of any portfolio. But as with champagne, you can have too much of a good thing. Too much diversification doesn’t look like a mistake at first glance; it looks like caution. But for many investors, overdiversification can do more harm than good.
To understand how diversification can go wrong, it’s helpful to understand first why it works so well. Harry Markowitz formalized the theory of diversification in 1952, demonstrating that when a portfolio contains investments that don’t move in lockstep with one another, poor performance by one asset may be offset by good performance in another.1 Spreading investments across unrelated sectors and asset classes can help reduce the chance that a single negative outcome such as a product failure, regulatory crackdown, or sector collapse can devastate a portfolio by minimizing volatility.
It doesn’t cost anything to hold a mix of investments such as different asset classes (stocks, bonds, alternatives, commodities) or types of securities such as domestic and international, or growth and value. It’s like a free lunch. But the thing about a free lunch is that overeating can cause an unfortunate case of indigestion.
At some point in an investor’s pursuit of diversification, each new investment added to the portfolio may do less to reduce risk and potentially do more to dilute returns. There have been a number of studies that have attempted to identify at what point adding more securities may result in diminishing returns, both in terms of risk reduction and reduced expected returns. One study by Frank Reilly and Keith Brown found that a portfolio of 12 to 18 stocks provided about 90% of the maximum diversification benefit.2
Overdiversification is sneaky, often creeping up on investors over time. Maybe a friend recommends an interesting ETF, and you buy it. An article in the financial press catches your eye, and you buy an interesting stock or an attractive mutual fund. Over time, you might find yourself holding 50, 60, or even more positions. By investing in what has piqued your interest, you might find that many of your investments are making similar bets.
According to research by Morningstar, one of the most common overdiversification issues arises from investors holding too many funds that overlap with each other.3 For example, an investor might hold three different large-cap growth ETFs, with each dominated by the same few mega-cap tech names. On paper, the portfolio looks diversified, but in truth, not so much.
With too many stocks in the portfolio, it becomes harder and harder to understand what’s actually driving portfolio returns. It becomes harder to make decisions and keep on top of things. Then there’s the financial drag; more funds mean more expense ratios, more transaction costs, and greater tax complexity. All of these elements are hiding in plain sight, quietly eating away at overall return. Legendary investor Peter Lynch, in his famous book One Up Wall Street, even coined a term for this – diworsification.4 This is the point at which adding more investments not only fails to generate any benefit but actually makes things worse.
So, how much diversification is enough? One academic found that 25-30 carefully chosen stocks can be sufficient to help minimize volatility and mitigate unsystematic risk, or the company-specific, sector-specific factors that diversification is designed to guard against.5 As noted above, the Reilly & Brown study found that about 12-18 stocks provided around 90% of the maximum diversification benefit.
The exact number depends on factors like investment goals, time horizon, and the differentiation between the actual holdings.
You might find that you only need 20 stocks to build a diversified portfolio. Our sweet spot is slightly higher, though. At Motley Fool Asset Management, our active ETFs typically have between 35 and 45 holdings, while our passive ETFs sit somewhere around 100—both aiming to deliver portfolios that are highly diversified, but not over diversified.
The point is that an investor doesn’t need hundreds or thousands of positions, but rather just the right ones. This is the point where the conversation shifts from diversification to conviction.
High-conviction investing sounds like something you’d hear from a fleece vest-wearing hedge fund bro, but it’s actually an important concept. It means concentrating your investment capital on a smaller number of meticulously researched positions, investments in businesses that you understand deeply and believe in for the long term.
As a high-conviction investor, you don’t chase after the latest hot tip or follow the herd. High-conviction investing is all about doing the hard work of scrutinizing financials, analyzing the competitive landscape, and developing an industry outlook. Based on this research and analysis, as well as a disciplined investment strategy, the investor acts.
With so much work involved, the investor can develop a focused portfolio that has diversification geared to help manage risk while investing only in a number of companies. It’s possible to apply the same philosophy to investing in mutual funds.
For any investor, the goal is to balance diversification against dilution. True diversification isn’t about volume. It’s about intentionality. Every investment in a portfolio should earn its place, and every investor should understand what they own and why they own it. If you can’t remember the reason you invested in something, it shouldn’t be in your portfolio.
Diversification is still one of the most powerful tools available to investors, but it’s meant to offer protection, not dilute thinking. The high-conviction investor focuses on building a resilient portfolio based on deep understanding and investments they believe in. Constructing a high-conviction, appropriately diversified portfolio built to weather a variety of market conditions is a worthy goal for every long-term investor.
At Motley Fool Asset Management, we’ve long been believers in high-conviction investing, and we use ETFs to express that belief. Explore our lineup of funds today.