4 Reasons Diversification Could Hurt Your Portfolio

One of the classic axioms of investing is: diversify, diversify, diversify. It is a practical way of minimizing exposure to the potential downfalls of any single investment. In other words, don't place all of your eggs in one basket. Most investors would agree that diversification is prudent. However, academia has taken this concept far beyond practicality, and lulls many investors into having a false sense of security, with hyper-diversified portfolios. The following four insights serve as a perspective on more appropriate levels of diversification.

1. The benefits of diversification quickly diminish when adding more than 30 holdings. To illustrate the benefits of diversification, it is helpful to understand two primary components of risk. Overall, market risks influence stocks indiscriminately, and cannot be diversified away with a larger basket of assets. No matter how diversified one is, if economic data sours, everything is susceptible to declines.

The other type of risk is company-specific risk. This type of risk can, theoretically, be eliminated by spreading your investment across various companies. Holding two stocks instead of one significantly reduces your company-specific risk. However, 95 percent of company-specific risk is eliminated by holding a portfolio of 32 stocks, according to Lawrence Fisher and James Lorie's well-known 1970 paper, "Some Studies of Variability of Returns on Investments In Common Stocks," published in the Journal of Business. It is not uncommon to see portfolios comprised of mutual funds with more than 5,000 underlying stocks represented.

2. Overdiversification guarantees average performance, at best. A portfolio comprised of even 100 stocks is spread so thin the investor can only hope to achieve returns consistent with the broader market. Factor in the costs associated with owning so many securities, and even average performance isn't possible. This is a core reason why many mutual funds underperform the broader market.

The benefit of reduced risk is too marginal to add any value, and it becomes impossible to generate alpha (outperformance). A skillful manager should take more concentrated positions, in order to enjoy the benefits of superior stock selection. As someone who has spent the last two decades studying the nuances of finance and stock selection, it pains me to see managers at the helm of strategies comprised of hundreds of stocks. Each company is unique, and very few offer a combination of fundamental attributes at a price attractive enough to warrant my investment.

3. Only the addition of a superior asset adds value to the portfolio. This may seem mundane, but it is worth mentioning because too often I am asked why I don't add physical assets to my portfolio. The message of diversification has become so distorted, that many investors find it necessary to add alternative assets to their portfolio. Adding an inferior asset for the sake of diversification increases volatility and erodes performance. Certainly, there have been isolated periods where the price of gold or collectibles has outpaced the performance of equities and fixed income.

Though I am confident this phenomenon is likely to repeat itself, I find it difficult to assess the intrinsic value of such nonproductive assets that cannot generate cash. Rather, it is a game of buying something you hope someone else will pay a higher price for down the road, also known as speculation. Incorporating an additional component with superior attributes to the portfolio is the only way to add value.

4. If you are going to diversify, then do so. In addition to adding a superior asset to the mix, one must also ensure the asset is not highly correlated to the portfolio. If the portfolio is highly concentrated in the health care sector, adding a pharmaceutical company does not offer the same diversification benefit as adding something from a different sector. Companies within the same industry often face similar risks and therefore, the benefit of diversification is limited. The correlation of the asset is inversely related to the reduction in expected volatility.

This concept is illustrated in conservative bond portfolios. People are often surprised to find an allocation of 80 percent bonds and 20 percent equities offers higher returns with less volatility than an allocation of 100 percent bonds. Because equities have low correlation to bonds, and a higher expected return over time, the return for each unit of volatility improves. However, the inverse is not true. A 20 percent bonds and 80 percent stocks portfolio will not be superior to a portfolio allocated entirely to equities. The volatility is lower because of the low correlation, but by adding an asset with a lower expected rate of return, the entire portfolio will achieve a lower return. To benefit a portfolio, the asset must have a low correlation and a favorable risk-to-return profile.

In summary, diversification is beneficial and a practical way of reducing risk. However, proper diversification must be done in a way that will enhance a portfolio, by adding a superior asset with a low correlation. The concept has been so mangled and exaggerated by academics that many investors are unintentionally stifling their performance in pursuit of fallacious risk reduction. Only by deviating from the average can one beat the average. Managers, who attempt to beat the market by veering ever so slightly, serve only to add additional costs with little additional value. Even if a manager correctly selects a stock that achieves spectacular performance, by allocating 1 percent of the portfolio to it, they will only enjoy 1 percent of the benefit. Too often, the fear of underperformance leaves investors hugging the index so closely that any alpha is insufficient to offset the fees. A good portfolio manager will utilize his or her skill set to invest in a small basket of stocks he or she believes will offer superior results.

Brett Carson , CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.

Advisory services offered through CWM, LLC a Registered Investment Advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine what is appropriate for you, consult a qualified professional. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. Stock investing involves risk including possible loss of principal.