Over-diversification occurs when an investor puts their money into too many investments. This could be too many investments of the same type or too many as in the quantity of investments that are in the portfolio. Diversification of a portfolio is spreading out a percentage of the money so that a portion of the portfolio contains stocks, bonds, mutual funds, certificates of deposit and other appropriate investments. Diversification creates the proper balance in the portfolio to reduce risk, while over-diversification offsets the balance and increases the risk.
According to financial experts, a properly diversified portfolio contains 15 to 30 different types of investments. Over-diversification occurs when the investment portfolio contains more than 30 different types of investment vehicles. While experts emphasize the importance of diversifying investments, most agree that there is a point where diversifying no longer provides the benefit of less risk. By spreading out investments among too many different investment vehicles, it adds a layer of risk because not all the products can be given an adequate amount of research and attention. Any savvy investor knows that an investment should be researched and followed to track its success or failure.
There are signs that indicate when a portfolio is not properly diversified, beyond the fact that the portfolio contains more than 30 different types of investments. The first sign is when the mutual funds in the portfolio contain a lot of the same investments. Mutual funds are a combination of stocks, bonds and other investments, so if the mutual funds in the portfolio have a lot of overlap, then too much diversification is present.
Over-diversification can also occur across different types of investment accounts. For example, if an investor has similar or the same investments in his personal investment portfolio and all of his retirement savings accounts, then his investments are not diversified enough to minimize risk and maximize the returns on the investments.
Another sign of over-diversification is when a portfolio holds a lot of privately traded investments. While it is fine to own some privately traded stocks, again there should be a balance between the private and publicly traded stocks in the portfolio. This is in addition to the other types of investments in the portfolio as well.
Over-diversification can be more of a problem than a help to the investor and the investment portfolio. The primary problem with over-diversification is that it may give an investor a false sense of security, putting him at risk of taking a big loss. While proper diversification does not eliminate risk, over-diversification puts the portfolio at a greater risk for losses, or rather, it prevents the investor from focusing on putting together a properly diversified portfolio that has a higher potential to be profitable.
