<p>The positive attributes of diversification are an accepted principle of modern portfolio theory and are often thought of as the only "free lunch" in finance. Diversification reduces risk because of the imperfect correlation of price movements. The challenge arises when investors diversify across a set of diversified portfolios, as opposed to diversifying across a set of securities with idiosyncratic risk. Finding the right balance between enough and too much diversification is an important point. </p>.<p>A few drawbacks that have been identified with over-diversified portfolios are increased costs of active management, enhanced exposure to tail risk events, increased temptation to use leverage, limited outperformance and underperformance in bull markets, return dilution, portfolio complexity, overlapping of holdings and a lack of conviction. </p>.<p>Limited outperformance & underperformance in bull markets: Over-diversification may result in a portfolio that closely tracks the overall market or a specific index. While this can reduce the risk of significant losses, it also limits the potential for outperformance since the portfolio is unlikely to deviate significantly from the market average. In strong bull markets, some well-diversified portfolios might underperform compared to more concentrated portfolios with higher allocations to outperforming assets. This is because the benefits of diversification become less apparent when most assets are experiencing positive returns.</p>.<p>Dilution of returns: As more assets are added to a portfolio, the impact of any single investment's positive performance on the overall portfolio becomes diluted. Even if one or a few investments perform exceptionally well, their positive impact may be offset by the performance of the other holdings.</p>.<p>Increased costs: Managing an over-diversified portfolio can be more expensive due to transaction costs, management fees, and other associated expenses. This can erode overall returns, especially if the portfolio is spread across numerous funds with varying expense ratios.</p>.<p>Complexity: Overly diversified portfolios can become complex and challenging to monitor effectively. This complexity may lead to difficulties in understanding the risks and potential returns of individual holdings, making it harder for investors to make informed decisions.</p>.<p>Overlap and correlation: Buying multiple mutual funds might look like a diversified portfolio, but if we analyse the holdings, then we will realise that there are a lot of common holdings amongst the mutual funds.</p>.<p>Lack of conviction: Holding a large number of funds can indicate a lack of conviction or a clear investment thesis. Investors may be better served by focusing on a more concentrated portfolio of holdings rather than spreading their resources too thin.</p>.<p>Market correlations: Market correlations are not constant, they change over time and during extreme market events, correlations among different asset classes and securities may increase. In such cases, the benefits of diversification may diminish as various investments move in sync with each other, potentially resulting in losses across the entire portfolio.</p>.<p>It's important to note that the level of diversification that is considered "over-diversified" can vary based on individual investment goals, risk tolerance, and market conditions. While diversification is generally a prudent strategy, investors should carefully evaluate the number and types of assets in their portfolio to ensure that it aligns with their financial objectives and risk preferences. It's also advisable to periodically review and rebalance the portfolio to maintain an optimal level of diversification.</p>.<p><em>(The writer is partner and co-founder, Upwisery Private Wealth)</em></p>
<p>The positive attributes of diversification are an accepted principle of modern portfolio theory and are often thought of as the only "free lunch" in finance. Diversification reduces risk because of the imperfect correlation of price movements. The challenge arises when investors diversify across a set of diversified portfolios, as opposed to diversifying across a set of securities with idiosyncratic risk. Finding the right balance between enough and too much diversification is an important point. </p>.<p>A few drawbacks that have been identified with over-diversified portfolios are increased costs of active management, enhanced exposure to tail risk events, increased temptation to use leverage, limited outperformance and underperformance in bull markets, return dilution, portfolio complexity, overlapping of holdings and a lack of conviction. </p>.<p>Limited outperformance & underperformance in bull markets: Over-diversification may result in a portfolio that closely tracks the overall market or a specific index. While this can reduce the risk of significant losses, it also limits the potential for outperformance since the portfolio is unlikely to deviate significantly from the market average. In strong bull markets, some well-diversified portfolios might underperform compared to more concentrated portfolios with higher allocations to outperforming assets. This is because the benefits of diversification become less apparent when most assets are experiencing positive returns.</p>.<p>Dilution of returns: As more assets are added to a portfolio, the impact of any single investment's positive performance on the overall portfolio becomes diluted. Even if one or a few investments perform exceptionally well, their positive impact may be offset by the performance of the other holdings.</p>.<p>Increased costs: Managing an over-diversified portfolio can be more expensive due to transaction costs, management fees, and other associated expenses. This can erode overall returns, especially if the portfolio is spread across numerous funds with varying expense ratios.</p>.<p>Complexity: Overly diversified portfolios can become complex and challenging to monitor effectively. This complexity may lead to difficulties in understanding the risks and potential returns of individual holdings, making it harder for investors to make informed decisions.</p>.<p>Overlap and correlation: Buying multiple mutual funds might look like a diversified portfolio, but if we analyse the holdings, then we will realise that there are a lot of common holdings amongst the mutual funds.</p>.<p>Lack of conviction: Holding a large number of funds can indicate a lack of conviction or a clear investment thesis. Investors may be better served by focusing on a more concentrated portfolio of holdings rather than spreading their resources too thin.</p>.<p>Market correlations: Market correlations are not constant, they change over time and during extreme market events, correlations among different asset classes and securities may increase. In such cases, the benefits of diversification may diminish as various investments move in sync with each other, potentially resulting in losses across the entire portfolio.</p>.<p>It's important to note that the level of diversification that is considered "over-diversified" can vary based on individual investment goals, risk tolerance, and market conditions. While diversification is generally a prudent strategy, investors should carefully evaluate the number and types of assets in their portfolio to ensure that it aligns with their financial objectives and risk preferences. It's also advisable to periodically review and rebalance the portfolio to maintain an optimal level of diversification.</p>.<p><em>(The writer is partner and co-founder, Upwisery Private Wealth)</em></p>