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Sunday, July 8, 2012

Avoid Overdiversification in Your Portfolio

Investment Frontiers Symposia
Investment Frontiers Symposia (Photo credit: apec2011ceosummit)
Everyone talks about diversification but hardly anyone mentions the tyranny of overdiversification. Portfolio diversification has been a foundation of investment management for decades. The basic idea is to hold different types of investments within the same portfolio to avoid getting crushed if and when the market tanks. Diversification isn’t designed to prevent losses, but rather, to minimize them. While most financial professionals advocate diversifying your investments, the problem of overdiversification is almost never discussed. What is it?
An overdiversified portfolio is one that holds too many of the same types of investments. Instead of owning a well-designed basket of various investments that complement each other, the investor who suffers from overdiversification ends up owning investments that appear different, but are essentially the same. What’s the end result? A portfolio with too much of the same thing.
Below is a snapshot of Portfolio X, which consists of just five holdings. Can you identify which holdings are overlapping? If you said ticker AGTHX, FCNTX, and QQQ – you’re right! Each of these investments, despite having different labels, own the same types of stocks; large cap growth companies. Owning these three investments within the same portfolio is a classic example of overdiversification.... Continue to read.
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