Common Investment Mistakes: Overdiversification
Over the past few months, we’ve been exploring the nine common mistakes I see people make when investing. Following our last discussion on Under-Diversification, this edition tackles its counterpart: Overdiversification.
Understanding Overdiversification
Overdiversification occurs when an investor spreads their investments too thinly across an excessive number of mutual funds. Simply put, what the investor owns is everything of everything, diluting their potential returns significantly. Moreover, each of these numerous funds carries its own management fees, further digging into potential gains. This form of excessive diversification was famously dubbed "Diworsification" by the iconic mutual fund manager Peter Lynch in his book One Up On Wall Street.
The Pitfalls of Target Date Funds
A prime example of overdiversification can be seen in Target Date Funds, commonly offered in employer 401(k) plans. Many of these funds hold upwards of 20 or more mutual funds. This is classic diworsification. These funds gradually change the allocation over time from equities to fixed income. As the target date approaches, the portfolio is allocated almost entirely to fixed income! This shift occurs precisely when a retiring investor needs to combat the rise in living costs over an average of 30 years—a challenge ill-suited to fixed income investments alone, often leading to depleted funds during retirement.
Optimal Portfolio Diversification
Contrary to the overdiversification seen in many portfolios, achieving optimal diversification doesn't require an overwhelming number of investments. A well-diversified equity portfolio needs only five or six different funds total, each holding around 100 securities. This level of diversification across roughly 500 stocks is sufficient to mitigate risk without diluting potential returns excessively.
Conclusion and Call to Action
The key to successful investing is not just diversifying, but diversifying wisely. If you're concerned about the balance of your portfolio or want to understand more about achieving optimal diversification, we're here to help.
Ready to review your investment strategy? Contact us today to ensure your portfolio is neither under nor overdiversified.
You can also catch up on our previous blog posts on Other Common Investment Mistakes:
Common Investment Mistakes: Investing for Yield
Common Investment Mistakes: Panic
Common Investment Mistakes: Overconfidence and Speculation Trading
Common Investment Mistakes: Using Politics to Make Investment Decisions
Common Investment Mistakes: Under-Diversification
Disclaimer: A diversified portfolio does not assure a profit or protect against loss in a declining market.