What Are Some Problems With Portfolio Diversification?

by Timothea Xi
Overdiversification can eat away at your returns.

Called "diworsification" by some investment advisers despite its mantra-like status in the financial community, diversification may not be the panacea to buffer your portfolio from market shocks after all, but could in fact harm it if used indiscriminately. When used in moderation and across distinct asset classes, diversification can indeed help to smooth out the rough edges of any one investment, but if it becomes an exercise in stockpiling every conceivable investment in your coffers, that well-intentioned technique of distributing holdings could turn your nest egg into a scrambled mess.

Same Asset Class

The fund research company Value Research warns of the lures of illusory diversification, as illustrated by one portfolio containing 20 mutual funds. Not only is the number excessive and unmanageable, but they mostly deal in mid- and small-cap funds. Financial advisers Buckingham Asset Management attest that investors often make the mistake of loading up their portfolios with investments in the same asset class in the belief that they're diversifying their holdings. However, they're actually exposing themselves to the same types of risk -- rather than spreading out that risk in a variety of baskets.

Too Many Cooks

More might seem better in the scheme of diversification, but when investors diversify their portfolios to the point of overdiversification, they can also inadvertently overcomplicate their lives -- as well as face the whammy of higher transaction fees, concentration of risk and adverse tax consequences, notes "U.S. News Money." Buckingham concurs, saying that investors lose economies of scale and the benefit of reduced fees when they spread out their assets thinly, and by investing with multiple advisers, they could be duplicating their holdings and incurring superfluous transaction costs. More trading can lead to higher capital gains taxes, says "U.S. News."

Lower Returns

When you invest in a hodgepodge of different instruments, what you are essentially doing, says self-directed investing site Arbor Investment Planner, is investing in an index fund. If buying an index fund is your intent, do it, it says, but don't replicate it through the mix-and-match method, which will drag down your returns with more mutual fund or transaction fees. Another issue with this approach is the fact that accruing more and more stocks, for example, will lead to your portfolio being more correlated to the overall market; that might be beneficial in a bull market, but if the market tanks, you're in hot water.

External Factors

You may think you're protected from the slings and arrows of the markets, as far as diversification goes, because you've prepared in advance and placed your money in supposedly low-risk bets, such as risk-parity funds that are diversified across stocks, bonds and commodities. However, as "Daily Finance" points out, unforeseeable events, such as intervention by the central banks and Federal Reserve, can throw these investments for a loop. In the face of potential reversals in monetary policies and their resulting effect on interest rates, risk-parity funds have endured large losses as of 2013, despite being composed of a diversified mix of instruments.

About the Author

Timothea Xi has been writing business and finance articles since 2013. She has worked as an alternative investment adviser in Miami, specializing in managed futures. Xi has also worked as a stockbroker in New York City.

Photo Credits

  • Jupiterimages/Photos.com/Getty Images