When you diversify your portfolio, you help lower its overall risk exposure by allocating funds among various asset classes. Diversification avoids relying too much on the performance of a single asset class, helping you weather economic uncertainty and grow your portfolio.
But is there too much of a good thing when it comes to diversification? Is it possible to over-diversify a portfolio?
What Is Over-diversification?
The Nest, a personal finance website, explains that over-diversification involves putting your eggs in so many baskets that, although you may be helping shield your portfolio from huge losses, you’re also reducing its potential for significant gains. With over-diversification, individual results may be limited if one portion of the portfolio goes up rapidly because that portion represents only a small percentage of the total portfolio.
However, no single approach to asset allocation is suitable for everyone. Each person’s needs, goals, and risk tolerance are different.
As opposed to over-diversification, proper portfolio diversification may reduce the effect of overall volatility by dividing risk among different kinds of assets. For example, a well-diversified portfolio might include a mix of traditional assets like stocks, bonds, money market funds, and certificates of deposit (CDs), along with alternative assets like real estate and precious metals. Over the long term, diversification can help smooth out swings in a particular asset’s performance.
Diversification can involve multiple asset classes as well as multiple assets within a single class. For example, someone looking to diversify their portfolio may buy one of the four major precious metals—gold, silver, platinum, and palladium—or they might purchase all of those precious metals to enhance their diversification within the precious metals asset class.
“Owning [multiple precious metals] simultaneously is the only way to get exposure to the unique supply and demand drivers behind each of them in the context of the modern market,” Visual Capitalist notes.
Risks & Examples of Over-diversification
Forbes explains that although it would be difficult to lose money because of over-diversification, you may be giving up gains or paying more money than necessary on fees by watering down your portfolio with too many asset classes or by holding the same assets within different “packages.”
Furthermore, too much diversification could make you lose track of precisely which assets you own. For instance, if you hold shares in two dozen companies, you may lack an in-depth understanding of each of those companies. As an old adage says, “Risk comes from not understanding what’s in your portfolio.”
Signs of an over-diversified portfolio include:
- A large number of individual stocks.
- An abundance of mutual funds in a single category, such as technology.
- An inability to adequately track your assets and their performance.
- A lack of agility when it comes to rebalancing your portfolio.
How to Help Avoid Over-diversification
Fortunately, it’s easy to avoid over-diversifying your portfolio. Here are six ways to help prevent over-diversification:
- Stay focused on maintaining a healthy level of diversification. Over the long haul, proper diversification can pay more dividends than over-diversification.
- Take your time. Be sure you understand each of the asset categories in your portfolio and the various components that make up each category.
- Steer clear of emotions. Try not to let your feelings get in the way of wise decisions about your portfolio.
- Don’t be swayed by market whims. Reacting to every up or down movement of the financial markets could cause you to spread your assets too thin.
- Regularly rebalance your portfolio and consider more rebalancing as your risk tolerance changes.
- Lean into assets with a long-term record of reliability, such as physical gold and silver.
Check Your Diversification.
Is your portfolio diversified? Sometimes it can be hard to tell. Take our quiz to find out and call U.S. Money Reserve to learn more about the power of precious metals within a well-balanced diversification strategy.