Whenever people start to invest, they have one notion: buy as many companies as possible! This is known as ‘Over diversification’ and it is hurting your investment potential! Here’s how you can avoid over diversification!
What exactly is over diversification?
Before we can delve deeper into how you can avoid over diversification we need to establish what exactly it is!
Diversification
We’ve probably all heard investment managers, investors and news anchors talk about “A well diversified portfolio”.
And most investors do strive for a portfolio to be well diversified! Investors from Warren Buffett to your average Joe aims for this!
A well diversified portfolio (following Rule One Investing guidelines) is one with holdings in 5-10 companies. These companies are in two/three industries that you are well acquainted with.
Here’s an example of a well diversified portfolio:
| Stock | Stock Ticker | Price ($) | Industry |
| Bob’s airline | BBA | 50.01 | Airline |
| Steve’s airline | STA | 334.59 | Airline |
| Luke’s Tech | LTC | 213.87 | Tech |
| James Tech | JTI | 21.76 | Tech |
| Matt’s airline | MATT | 32.39 | Airline |
| Tom’s Tech | TTH | 297.04 | Tech |
| John’s Bank | JHB | 179.78 | Finance |
| Ted’s Insurance | TDI | 116.37 | Finance |
| Mike’s Credit Union | MCU | 930.52 | Finance |
Assuming that this person is well acquainted with all three of these industries, and has followed Rule One to buy them, this portfolio is a well balanced one!
Yes, it may not be pretty, with this portfolio only containing nine companies. But the person who owns this portfolio is almost guaranteed to make more than the markte average!*
*Assuming he/she follows everything else set out by Rule One!
Over Diversified
A new investor often hears the above information and goes:
“Ok, so if I buy shares in that medical company, and that airline, and that tech firm and that toy company and that media company…” (And go on and on with several more companies)
By the time they’ve gotten around to investing in these companies, they have over diversified! It isn’t necessarily the number of companies you’re investing in, but the number of industries too!
Take this (made up) portfolio as an example of an over diversified portfolio:
| Stock | Stock Ticker | Price ($) | Industry |
| Dave’s Media | DMD | 532.89 | Media |
| Tom’s Tech | TTC | 297.04 | Tech |
| Bob’s Airline | BBA | 50.01 | Airline |
| John’s Bank | JHB | 179.78 | Finance |
| Steve’s Medical | STM | 487.59 | Medical |
| Ted’s Toys | TTYS | 789.65 | Toys |
| Mo’s Boats | MBTS | 43.20 | Boats |
| Fred’s Furniture | FFF | 233.87 | Furniture |
| Steve’s Airline | STA | 978.99 | Airline |
| John’s Sports | JSP | 419.76 | Sports |
| Fin’s Videos | FVD | 15.09 | Video |
| Nate’s Movies | NMV | 78.93 | Entertainment |
| Joe’s Costmetics | JCM | 632.00 | Cosmetics |
| Alan’s Autos | ANTU | 12.43 | Cars |
| Max’s Clothes | MXC | 778.89 | Apparel |
| Kevin’s Cars | KVK | 56.12 | Cars |
| Ned’s News | NDN | 990.35 | Media |
As you can see, the owner of this portfolio has holdings in many companies in many industries, and as such is certainly over diversifying their portfolio!
What’s classed as over diversified?
That is a tricky question to answer. According to Rule One, it’s when you own more than 10 stocks.
However, I disagree. Yes, owning more than 10 stocks is a risky move when it comes to over diversification, but I would also add more than three industries to that list too!
Because, you probably aren’t an ‘expert‘ as you may believe if you are an ‘expert’ in more than three industries. Yes, if these industries are very (and I mean very) interlinked, this may be the case.
However, as a general rule, this probably isn’t going to be the case!
The effects on your portfolio
Some investors would disagree with me when I say that over diversification is bad. I’m not too sure why, but some do. Not many, but still a few.
They say that over diversification doesn’t hamper your portfolio. But I would disagree!
The negative effects on your portfolio as a result of over diversification are:
- Lowers your overall stake in a company- you can’t reach that 0.01% stake because your other smaller investments take that away from you!
- Exposes you to too much risk- instead of having to worry about one of ten thoroughly vetted companies from going under, you now have to worry about three out of twenty- much riskier!
- Makes vetting difficult- As per Rule One, you should thoroughly research your investments. It’s much easier to vet ten stocks than it is twenty!
- More in transaction fees- it’s often said that fees kill the average investor. But by buying into so many companies, you are essentially wasting so much of that money in fees!
- Often focus on short term rather than long term value- you likely can’t find twenty amazing companies that will keep and grow their value through a twenty year time span. As such, you focus on the short term rather than the long!
How to avoid over diversification
There are a lot of materials online telling you how you can avoid over diversification, but they don’t tell you how to avoid over diversification.
Do your research, but stick to a few stocks
Do one industry at a time. Research all of the main players in that industry, find one or two at maximum and settle for them there.
For example, the aviation industry, you’d look at all the major companies (Boeing, Airbus, Embraer, Bombarider etc.) and then settle on one of those companies. Two at maximum.
Only buy one stock at a time
Once you’ve found the rights stocks, and the time is right to start investing, only choose one. Once you’ve bought into that one company, you wait a few days, weeks or even months, until the other industries/stocks collapse.
Then you invest in those also!
Meditate
I’m not one of these hipster types, but meditating on your stocks certainly helps! It will allow you to think about whether you really want (or need to!) invest in another stock!
Be patient
After doing your research, meditation and final research, wait. Wait until their is a recession or the market crashes. Then invest heavily!
Refrain from letting your emotions get the better of you
By the same token, don’t allow the already emotional stock market world to let you get even more emotional. Use the meditation I spoke of earlier to help you.
By removing your emotions from these things, you allow yourself to see the whole picture. As a result, you make better decisions- decisions that help you to avoid over diversification!
Focus on long term
As Warren Buffett once said “If you can’t hold a stock for ten years, don’t hold it for ten seconds!” This is the same here! (It also helps to remove the short term incentive that surrounds over diversification!)
Know the importance of quality
If you’re searching for above average returns, you are going to have to buy quality stocks, rather than twenty mediocre stocks!
Check your portfolio regularly
Ok, so there are inherent issues with doing this.
Don’t wait until your quarterly report, or until the latest news hits the mainstream media. You should try to check it every so often, to evaluate whether or not you’re over diversifying.
Sell/buy more of your “Non-traded” investments
“Non-traded” investments are investments in things like private companies. Yes, these non-traded investments may be integral to your investment portfolio, but too much or too little invested in them may cause over diversification!
By analyzing how much over diversification you have, you will know how much to buy/sell. By doing this, you are helping yourself to avoid over diversification, as you’re removing an over investment in one investment category!
What to do if my portfolio is over diversified
So let’ say that you’ve really vigilant and have tried to avoid over diversification at every point. But for some reason, there’s an issue and you have over diversified. What should you do next?
- Breathe
- Do nothing
- Wait for a short term peak (such as a merger, good annual report or something else that makes a business strong!)
- Sell part of that stock (or all of it, if you’ve truly over diversified!)
- Re-evaluate
- Move on
- Learn from your mistake
- Keep on investing!
How else can you avoid over diversification? Tell me in the comments!
