How Too Much Investment Diversity Can Cost You

By Damian Davila on 25 August 2016 0 comments

Financial experts agree that you shouldn't to put all your eggs in one basket. But just like with everything else in life, moderation is essential to truly reap the benefits of diversification. Spread out your investment funds into too many funds and you'll end up with a subpar portfolio bogged down with excessive charges and, even worse, potentially more risk than you're willing to bear. Here are four warning signs that you may have your investments in too many baskets — and how to fix it.

1. Paying Too Much in Investment Fees

The more that you branch out of plain vanilla investments, the more likely that you'll end up paying more investment charges and fees. Take, for example, the portfolio that Warren Buffett has laid out in his will: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund."

Let's take a look at the potential investment fees of such a portfolio.

Since the Oracle of Omaha prefers Vanguard and chases low fees, let's assume that both investments are in index funds. It's safe to assume that he meets the $10,000 minimum investment required for the Vanguard Admiral index funds. So, he allocates 90% of his portfolio to the Vanguard 500 Index Fund Admiral Shares [Nasdaq: VFIAX], which has a 0.05% expense ratio, and 10% of his portfolio into the Vanguard Short-Term Government Bond Index Fund Admiral Shares [Nasdaq: VSBSX], which has a 0.10% expense ratio. For a $10,000 portfolio, Buffett would pay $55 in investment fees.

If Buffett were to start diversifying into other types of investments, he would very likely run into higher expense ratios. For example, the Vanguard New York Long-Term Tax-Exempt Fund Admiral Shares [Nasdaq: VNYUX] has a 0.12% expense ratio (despite its $50,000 minimum investment requirement!) and the Vanguard Interm-Tm Corp Bd Index Admiral [Nasdaq: VICSX] has a 0.25% purchase fee on top of its 0.10% expense ratio. Assuming that he were to allocate 50%, 30%, 10%, and 10% to the New York muni bond fund, S&P 500 index fund, short-term government bond index fund, and the intermediate-term corporate index fund, respectively, Buffet would pay $220 on investment fees!

How to Fix It: Calculate your current total of investment fees across all your holdings. If the total is above what you're willing to pay (a useful rule of thumb is that anything beyond 1% of your total investment is too much), then it's time to focus your investments in lower-cost options.

2. Rebalancing Portfolio More Often

Speaking of fees, there is a higher chance that you'll run into more of them when you hold lots of investment categories. In the 90%-stocks-and-10%-bonds portfolio example, you only need to keep track of two funds. This means that figuring out when your portfolio is no longer meeting your target asset allocations is straightforward — and you may not need to do it as often. For example, you could set a target to rebalance when 80% of your portfolio is in stocks and 20% in bonds.

On the other hand, spreading your money out too thin can complicate keeping track of asset allocations and make you trade more often. Here's an example: Assuming a target 3.5% allocation in an emerging markets index fund, big market swings could force you to buy or sell many times throughout the year, triggering many charges. From front-end loads to back-end loads, there are plenty of investments to keep an eye on. And yes this even applies to 401K accounts! (See also: Watch Out for These 5 Sneaky 401K Fees)

How to Fix It: Tabulate how much you're incurring in fees on top of the regular annual expense ratios of your portfolio holdings. If that percentage is too high, or consistently increasing throughout the years, you need to consolidate your portfolio into fewer holdings.

3. Experiencing Diminishing Returns

Of course, you might be thinking that the extra returns of a very diversified portfolio may more than compensate for those additional fees and charges.

Let's bust that investment myth.

In a joint-study by The Wall Street Journal and Morningstar, the portfolio that generated the highest return over a 20-year period was a 70-30 mix of U.S. stocks and bonds, yielding a 9.1% annualized return. A portfolio with 40% in U.S. stocks, 20% in U.S. bonds, 10% in foreign developing market stocks, 10% in international bonds, and the rest in a mix of investments, including emerging market stocks, commodities, and hedge funds, yielded only an 8.8% annualized return.

How to Fix It: Measure each of your funds against its respective benchmark. If an investment has been missing the benchmark for too many quarters or years, it may be time to cut that fund loose.

4. Owning Too Much of the Same or Wrong Type of Investments

Another issue with putting many eggs in many baskets is that you can unintentionally end up with more eggs than you thought in a particular basket or, worse, a wrong basket.

Let's assume that you hold an index fund tracking the S&P 500. As of August 8, 2016, that means that your portfolio would hold about 3.08% on Apple Inc, 2.40% on Microsoft Corporation, and 1.53% on Facebook Inc. Class A shares. If you were to also hold an index fund on the technology sector, you'll probably end up increasing your holding on each one of those investments. For example, the Vanguard Information Technology Index Fund Admiral Shares [Nasdaq: VITAX] has those same three stocks among its top four largest holdings.

Additionally, if you're open to throwing more money around investments, you could end up buying some investments that fail to meet your investment objectives. Remember the late 1990s dot-com bubble? How about 2008's housing bubble? During those times, too many individual and institutional investors were buying financial instruments that they shouldn't have been purchasing. If you force yourself to allocate 5% "somewhere," then you could end up with the wrong type of investment.

How to Fix It: First, read the prospectuses of your mutual funds and other accounts and understand their actual holdings. Using this information, you can spot whether or not you hold too much of the same investment. Second, review your investment objective (ie; income vs growth) and evaluate whether or not your current investment funds qualify for that objective.

The Bottom Line

Holding all of your money in a single stock is definitely not a good idea because it would have a 49.2% average standard deviation (a measure of risk). At 20 stocks, your portfolio risk is reduced to 20%. However, every additional stock added to your portfolio will only further decrease your portfolio risk by about 0.8%.

The evidence suggests that due to greater returns, very marginal risk reductions, and lower fees over time, you would be better off with simpler diversification on stocks and bonds. Some financial advisers suggest that when you have more than 20 stocks or mutual funds, you're actually minimizing returns instead of maximizing them. So, before adding that extra holding, keep in mind that an index fund tracking the S&P 500 is already splitting your investment into 500 baskets!

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