How Much Diversification is Necessary?

How Much Diversification is Necessary?

by Ben Carlson, A Wealth of Common Sense

A few readers have asked:

How much diversification within my portfolio is necessary?

I’ve received a variation of this question a number of times over the past few weeks. I can understand why individual investors would have a difficult time figuring this one out.

The choices these days for building a diversified portfolio are nearly endless. Not only do you have to choose among asset classes and then between active funds, index funds, ETFs, closed end funds or individual securities, but you also the different variations to consider within each including large cap, mid cap, small cap, growth, value, momentum, yield, international, emerging markets, REITs, liquid alts, treasuries, corporates, TIPs, junk bonds, commodities and I could continue.

To make matters worse, every market practitioner goes out of their way to try to convince you that they have figured out the formula for the perfectly diversified portfolio. Their portfolios offer the are the best returns at the lowest cost with the lowest risk using the best risk management techniques. In an industry overflowing with overconfidence it becomes nearly impossible to choose between the products with the best sales people and the ones that make sense for you.

Diversification requires finding the right balance between eliminating unsystematic risk (risk that’s specific to single securities or industries) and di-worsification by adding too many overlapping funds. If you’re not diversified enough you increase your portfolio’s risk, but diversify too broadly and you could end up paying higher fees with increased complexity for no reason.

One of my guiding portfolio management principles is that investors should have a reason for every asset class, strategy, fund or security in their portfolio. This is a step you can’t ignore if you wish to create a truly diversified portfolio that isn’t just a jumbled mess of different funds that sounded good at the time over the years because everyone was talking about them.

Here are a few things I have laid out in the past that I consider when thinking about building a diversified portfolio:

1. The asset class should offer diversification and correlation benefits but I acknowledge the risk factors and the relationships between asset classes can and will change over time.
2. Asset classes and their risk characteristics should be different from one another. This could includes differences in geography, economic development, security structure, risk factors, income payments or investment styles.
3. The asset class should have an expected long-term return above inflation.

Will a simple stock/bond portfolio do the trick? I think so. Could you do better than a simple stock/bond portfolio? I think so. Could you also do much worse than a simple stock/bond portfolio? Absolutely. And I would argue that most investors end up doing worse because they try to do better.

There are potential benefits for those investors who would like to put in the time to understand the various sub-asset classes and strategies. Do you need to diversify within asset classes by strategy, market cap or risk level? As with most of these types of question, it depends. It depends how complex you’d like your portfolio to be. It depends how well you understand the different variations of stock, bond or alternative investment categories. It depends on how different you would like your portfolio to be from the broad market averages.

And it depends how you plan to utilize diversification within your portfolio. Wider diversification works much better if you’re able to utilize volatility to your advantage by leaning into the underperforming parts of your portfolio and reinvesting during those times. Some investors simply can’t or won’t be able to pull this off.

The secret here is that there is no secret. There’s no perfect amount of diversification, just like there’s no perfect portfolio. It’s only know with the benefit of hindsight. And if you plan on diversifying your portfolio you’re always going to have to accept the fact that your portfolio will never be perfect. There will always be at least one lagging component, maybe more.

And that’s probably the surest sign that you’ve hit the threshold for being diversified. If there’s not something in your portfolio that you currently hate holding onto in the current environment, you’re not diversified enough.

Further Reading:
In Search of the Perfect Portfolio

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My new book, A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan, is out now.