Too Much Diversification Can be a Bad Thing
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In an attempt to build a well-diversified portfolio of passively managed investments (or any investments for that matter), investors can diversify their portfolio to the point where it will hurt them rather than help them. This attempt to diversify away all risk is a trap.
Diversifying away every possible aspect of risk entailed when investing is simply impossible and can cost the investor in fees, trading costs and taxes. It can eventually lead to the downfall of their long-term investment plan. Investors can be so cautious as to invest in every possible area of the financial markets, both domestic and international, so that when one area performs badly, they hope another area will be able to compensate them for that loss. That is the basis for diversification, but many people get caught and diversify too much, in effect over-diversifying. By investing in every aspect of the markets, an investor can get carried away. They believe they can diversify away all types of risk associated in investing, which isn't possible. Over-diversifying will do more harm to the investor's portfolio then good, given the fact that if an investor has only a little money invested in each area, the possible gains will be so small that when trading costs and other fees are taken into account, the investor may actually have lost money rather than made it. It's very easy for the investor to get caught in this dilemma.
Many investors, both individual and institutional alike, get caught in this trap in order to help themselves sleep better at night or in order to please their clients. Diversification in investing is a great thing, but only when you split a healthy amount of money among various asset classes. What is a "healthy" amount? This is usually $1,000 or more devoted to each investment (only if necessary). If that is not possible, the next best strategy is to find the cheapest index fund that follows the index you want to invest in and whose minimum investment is not too high. If you want to invest in the S&P 500 and you only have $300 to invest, attempt to look for a fund that accepts $300 or less in investment, and from there narrow down the choices to the cheapest one.
The Right Way to Diversify
The following is a hypothetical table of possible returns based on $1,000 invested in a domestic and foreign index fund after fees and expenses are accounted for.
| Fund Name | Amount Invested | One Year Return | Fees & Expenses | Total Return |
| Domestic Index | $500 | 5% | 0.20% | $523.95 |
| Foreign Index | $500 | 12% | 0.20% | $558.88 |
The table above is an example of the amount of money that can be made with only $1,000 invested ($500 in two funds). After one year, you made $82.83 (after fees and expenses), a decent amount considering you only started with $1,000. However, the table used positive one-year returns for each fund, and it is likely that some years your funds will be down and others they will be up. It's best to ignore the short-term fluctuations of specific indices and index funds in general, and to not deter your long-term investing objectives.
If you don't have a lot of money to invest, stick to one or two index funds (an S&P 500 fund will likely work) rather than going crazy and diversifying into 4+ index funds. Owning one or two funds with $1,000 to invest is acceptable, and encouraged. Once you stray from that and start buying more, you fall into the over-diversification trap and are doing more harm to your investments than good.
The Wrong Way to Diversify
By investing small amounts in many index funds, the opportunity to earn a decent return greatly decreases. Once you subtract the many fees, trading costs and taxes an investor faces, odds are you may come out with a negative return. Since most investors seek a positive return on their investments, you will want to limit the risk and costs you will face. The best way to do this is through diversification and a strong, balanced asset-allocation of index funds (as shown in the above chart and as will be explained later). The next table illustrates what can happen if you have $1,000 invested in four different index funds.
| Fund Name | Amount Invested | One Year Return | Fees & Expenses | Total Return |
| Domestic Index | $250 | 5% | 0.20% | $261.97 |
| Foreign Index | $250 | 12% | 0.20% | $279.44 |
| Small Cap Ind. | $250 | 3% | 0.20% | $256.98 |
| Mid Cap Ind. | $250 | 4% | 0.20% | $259.48 |
While what you make over the short-term really doesn't matter if you're a long-term investor, the above table is an example of over-diversifying, especially if you don't have a lot of money to invest to begin with. The above table does not even include transaction costs and trading fees. In the end, your return may be negative when those costs are taken into account.
How Many Funds Should You Own?
The following table is a table gives you an idea of how many funds you should own for how much capital you have invested.
| Amount Invested | Number of Funds You Should Own |
| Less than $1,000 | 1-2 |
| $1,000-$5,000 | 2-4 |
| $5,000-$10,000 | 4-7 |
| $10,000+ | 7-10 |
In many cases, an investor will have more than $10,000 under management. However, the same figures in the table hold true. It is likely best for the investor to own no more than 10 index funds at a time, as it makes it easier, more efficient and cheaper to own less than 10 funds rather than over-diversifying. If you own more than 10 funds, you need to assess your goals, risks and possible rewards and then take the over-diversification case into account. In the end, ask yourself: "Do I really need this many funds in my portfolio?" Your answer will likely be "No", as you will have found you are overlapping, (the process of owning one fund that replicates the same index, owns the same stocks, invests with the same objectives, etc.) and in many cases not having sufficient capital invested in each fund to generate a decent long-term total return.
More Invested Capital = Possibility of Larger Long-Term Returns
The more money you devote to one fund, the more money you can make, even if the total return stays the same. As you invest more in a fund or funds, you have to take compounding into effect and the fact that, with every positive return you achieve with more money invested, you are generating more capital per every dollar invested. If you only invest $100 and get a 10% return, you walk away with $110. However, if you invest $1,000 and walk away with a 10% return, you walk away with $1,100. In the first case you made $10, and the second case you made $100, even though your return stayed the same. This example shows that the more capital you invest, the higher possibility of walking away with more money, even though the percentage return is the same. By over-diversifying,
Don't Forget to Invest
Remember, even if you do not have a lot of money to invest, it's always important to invest nonetheless. If you cannot invest much ($1,000 or less) then invest in two or three index funds. After you do this, continue to save and add to the amounts invested, as you will keep purchasing in at different prices, regardless of the stock market's general direction. By doing this you are using another strategy that reduces the volatility, both short and long-term of a security. The benefits of dollar cost averaging (DCA) in index funds will likely work wonders for you over the long-term.
Simplicity
Investors complicate investing too much, and in effect make it harder than it really is. Diversification is a great tool because it's a simple way to reduce the overall risk you take on in your portfolio. Diversification is simple, and by over-diversifying you are complicating investing too much. When you over-diversify, you are going to constantly need to adjust the amount invested in each fund in order to rebalance your asset allocation. When you too own many funds (in some cases people own more than 10!) you need to constantly rebalance your asset allocation. Once you do this, you are incurring many fees and expenses, trading costs and in the end, possibly taxes. The overall effect from these various costs will erode the overall investment you have. You meant good by rebalancing your asset allocation, but ended up harming it. Investing is best when you keep it simple. In this case, diversify, but don't over-diversify!
Invest According to Risk Tolerance & Goals
You should invest according to your own risk tolerance, goals and remember to stick to your long-term investment plan. Only invest as much money as you deem necessary and as much money as you believe will fit into your overall asset allocation and the opportunity for long-term capital gains. As you begin to invest more and more, the trap of over-diversification becomes harder and harder. If you have a portfolio of $100,000 (or any investment), use diversification properly and have a well broken down asset allocation, you will likely be a successful long-term investor.
Wrap-Up
Diversification is important and this article is not intended to sway you from diversifying. You should always diversify, as it helps reduce the overall risk of your portfolio. Diversifying is smart and important for all long-term investors, but over-diversification is not. By diversifying, you are helping to reduce risk while increase your chance at a decent long-term total return. When you over-diversify you are reducing risk too much (in a possible attempt to reduce all of risk) and you are decreasing your chance at a decent long-term total return. The less you invest in a particular investment, the less you can return. In many cases, after all costs are taken into account, the total return may be negative because the initial return was so minimal that not enough money was invested to generate a decent return.
In many cases, when over-diversifying, investors do not realize they are even engaging in it. Over-diversification costs you in many ways, and is harmful to your wealth, not beneficial. Diversification is beneficial and is a tool that should be utilized to reduce the overall risk you are taking while investing. Always remember: diversification is good, over-diversification isn't. If you follow that, you will ultimately become a more successful long-term investor. Remember the following key points from this article:
- Invest "healthy" amounts in each index fund, as the more you invest, the more opportunity over the long-term for a larger total return.
- Don't over-diversify with small amounts of money. Diversification is a great investment tool, but only when not over-used.
- Fees, expenses, trading costs, transaction fees and taxes all erode your overall investment and in cases of over-diversification, can actually live you with a negative return when they are taken into account.