How Diversification Became “Di-Worsification”

Charles Dickens once wrote that virtue, carried to excess, could become vice. 

If he were a modern financial expert, Dickens could be talking about portfolio diversification. Diversifying the kinds of assets you hold helps you to maximize potential gains and minimize risk. But when diversification is carried too far, it becomes “di-‘worse’-ification.” 

Having too many investments in a portfolio eliminates both the potential for extra gains and the protection against excess risk. And yet that’s exactly what countless investors, and even advisors, are doing. Building portfolios with hundreds and hundreds of individual investments, they’re champions of the idea that there can never be too much of a good thing. But they are dead wrong.

True diversification involves counterbalancing types of assets that behave differently in different market conditions. By investing in assets with less correlation to each other, we gain exposure to a cross-section of growth opportunities. And because all our eggs are not in one basket, our portfolios may be insulated against a crash in any one asset class.

Diversification isn’t just some kind of popular wisdom—it’s rooted in respected academic research. The Fundamentals of Investments for Financial Planning, published by The American College, explains that true diversification doesn’t require a myriad of investments: “Research has repeatedly shown that a relatively small number of stocks (about 30) is sufficient to obtain most of the risk-reduction potential of diversification.”

When a portfolio exceeds that number, diversification’s benefits vanish. Specifically, the portfolio becomes increasingly exposed to market volatility. In plain terms, the more of the market you own, the more your portfolio will simply mimic the market. Your optimized balance between risk and return will disappear, so that when markets go down, up or nowhere, your portfolio will do the same. 

Then there’s the matter of costs. The more securities or funds you own, the more you are paying in sales and management fees. Especially in today’s modest return environment, these fees can eat up a large percentage of your returns. What’s more, the complexity of over-diversified portfolios makes them difficult to analyze. Which investments are helping and which are hurting? With hundreds upon hundreds of possibilities, it can be nearly impossible to tell.

One reason over-diversification is so prevalent is that many advisors “diversify” their client portfolios using mutual funds. A typical advisor may recommend a large-cap fund, a mid-cap fund and a small-cap fund. He may balance out a “value”-style fund with a “growth” style fund. He may add additional funds to gain international and emerging-market exposure. 

With each fund holding 50 to 100 stocks, you may soon be di-worsified into a portfolio with thousands of individual securities. That becomes a recipe for mediocrity at best, and disaster at worst. 

At Taylor Frigon Capital Management, we adhere to diversification in its true sense—and to some people that seems radical. We manage just two strategies: our Core Growth Strategy, which currently has 38 holdings, and our Income Strategy, which current has 42 holdings. 

Together, these two simple, straightforward strategies contain about 80 securities. Each strategy is fully diversified and constructed to complement each other to offset risk and optimize reward.  

Our approach, using rigorous in-house research to identify a limited number of exceptional securities across industries and sectors, has been validated by performance. From its inception on January 19, 2007, through the first quarter of this year, the Core Growth Strategy has posted an annualized return of 8.34% after fees. By comparison, the S&P 500 has returned 6.87%, and the Russell 3000 has returned 7.19%.

Our Income Strategy, built to deliver consistent cash flow and dampen volatility, has returned an average of 5.29% per year over the same period, after fees. That’s competitive with the S&P 500’s return—with much less risk. 

Past performance does not guarantee future performance, in our strategies or in any investment (for our performance disclosure, please click here) . But we believe our streamlined strategies are a testament to the power of diversification at its best. Please feel free to contact us for more information.

Main Points: 

  • Excess portfolio diversification becomes counter-productive “di-worsification.”
  • Di-worsification eliminates the valuable balance of risk and return and exposes investors to increased risk.
  • Diversification is most effective when portfolios consist of 40 individual holdings. 
  • Excess diversification creates more risk, higher costs and more confusion.
  • Di-worsification often occurs when advisors recommend multiple mutual funds.
  • Taylor Frigon strategies have achieved strong results with “pared-down,” true diversification.
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