When it comes to investing, one of the basic pieces of advice given to investors – large and small – is to ensure their portfolio is well diversified to help protect their investments against volatile markets.
The idea of ‘not putting all your eggs in one basket’ is perfectly sensible, but like most things, you can go too far.
“Diversification makes good sense, but you need to be careful how you apply it,” explains AustralianSuper manager portfolio control, Alistair Barker.
How do you achieve diversification?
The idea behind diversification is simple. “The general principal is the concept of spreading your investments so you aren’t in a position where any one event or issue causes you to not meet your investment objectives,” Barker explains.
That means investing in a variety of companies, industries and regions in different asset classes.
“Holding four different bank stocks is not being diversified, as they are all likely to perform in a similar manner when things go wrong,” Barker says.
How does over-diversification occur?
Although diversification can help to reduce portfolio risk and volatility, it is possible to overdo it. Often investors create an overly diversified portfolio by accident, as they ‘collect’ a range of different assets and investments as the years pass.
Investors can also succumb to the lure of the latest top performing asset or managed fund, adding it to their existing portfolio without looking at how it affects the investments they already hold, or whether it duplicates their current investment in a particular asset class.
What are some of the dangers of over-diversification?
- Reduced investment returns – Over-emphasising diversification can come at the expense of higher returns. “A key pitfall is investing in assets that don’t give good returns for the sake of achieving greater diversification,” Barker warns.
- Increased portfolio complexity – This is a common problem, Barker says. “If you have lots of things in your portfolio, you have a lot to look at and that makes it harder to monitor and stay on top of what your overall portfolio is doing.” In addition, multiple investments may require smaller commitments of capital. Investors often pay insufficient attention to their selection and ongoing monitoring.
- Diversifying across “diversified” funds – many super fund investment options (such as AustralianSuper’s pre-mixed investment options) are designed for members with particular investment horizons, and are diversified across a range of asset classes and managers. As a result, diversifying across a range of these types of funds is generally unnecessary.
- Increased risk of overlapping investments – Picking a little of this and a little of that without considering how the underlying assets overlap can actually increase concentration risk. This is when a large portion of your portfolio ends up invested in a single type of asset or market sector.
- Reduced impact from successful investments – Having too many investments means the positive contribution made by those that are successful will have much less influence on the performance of your total portfolio. For example, active managers favour the sectors and stocks they think will outperform. Having too many managers with different views can cancel each other out, so you end up with performance closer to an index return.
- Higher costs and fees – Buying and holding lots of assets can result in high transaction and operating costs for your portfolio.
- Complex tax position – Large portfolios make tax time difficult and can create tax inefficiencies, with high turnover managed funds often generating expensive tax bills.
Four signs your portfolio may be over-diversified
- Owning too many managed funds in a single sector or region (e.g. investing in both Australian large cap and S&P/ASX200 share funds).
- Owning a large number of individual direct shares (e.g. 30 plus Australian companies).
- Holding managed/exchange traded funds and direct shares covering the same industry or region.
- Not identifying any overlapping assets among your direct share, managed fund and super investments.
Time – the greatest diversifier of all
An appropriately diversified portfolio needs to match the length of time you plan to be invested.
According to Barker, investors need to remember the biggest diversifier is time itself, as it smooths out variations in investment returns. “If you have a medium to long time horizon, then investment volatility reduces with the passage of time.”
Younger investors have more time to ride out the impact of volatility on their retirement savings and investments. They can also use techniques like making regular super contributions and ‘dollar cost averaging’ (where fixed amounts are invested on a regular schedule, regardless of the price of the asset).
“By diversifying their entry points for adding new investment assets, they reduce the impact of volatility. The reality is, short-term market volatility is largely irrelevant over 40 years of contributions into the super system,” Barker explains.
Conversely, investors with a short time horizon may need to be more active in managing the volatility risk in their portfolio.
As they will be invested for a shorter period, investors in the retirement phase of their life may need to adjust and diversify their asset allocation towards lower volatility assets.
- Diversification can help to protect an investment portfolio against risk and volatility, but too much can create problems.
- A properly diversified portfolio invests in a variety of companies, industries and countries, as well as a range of different asset classes.
- Time is an important diversification tool and helps reduce the impact of volatility.
- Over-diversification creates a number of dangers including reduced returns and higher costs.
- Check new investments do not overlap existing assets prior to adding them to your portfolio.