A diversified portfolio is one of the keys to a successful long-term investment strategy. But can your assets ever be too diversified?
Technically, no — there are always new avenues for investors to explore to spread out risk. That said, because you likely don’t have the time and resources to commit to attaining the perfect mix of funds, it is easy to over-diversify in certain areas. You don’t want to have so many holdings that you’re paying unnecessary fees or can’t keep tabs on your investments.
“The big risk of over-diversifying is that you saddle yourself with too many holdings to monitor and the oversight process can grow unwieldy,” says Christina Benz, Morningstar’s Director of Personal Finance. “Additionally, your portfolio might end up looking a lot like the broad market but you’ll likely be paying much more for that portfolio than you would a cheap broad-market index fund or ETF.”
That last part is key. If you are invested in inexpensive, broad-market index funds, as Two Cents and most personal finance experts recommend for retirement savers, then there’s no need to spend the time, energy and money researching and investing in funds that expose you to the same parts of the market. Because what you’re doing is buying into a sort of faux-diversification.
According to Morningstar, research has indicated that “when confronted with too many choices, investors will divide their assets evenly across all the options, instead of selecting only suitable investments and allocating according to their financial goals.” This naive diversification, as Morningstar calls it, will hurt your retirement savings more than it helps: You’re paying four times more on average for the same exposure offered by more inexpensive funds, Morningstar found.
The average investor can attain proper diversification by choosing one or two funds within an investment class, says Cheryl Ober, a fee-only Certified Financial Planner. Beyond that, there’s no real increased return or lessened risk.
“What people don’t realise is that when they invest in two or three large cap growth funds, for example, when you look at the breakdown of the industries or companies that the various funds are investing in, they are all investing in pretty much the same company stocks,” says Ober. “Most funds in a particular category are fairly similar in that there are a finite number of stocks that they can be invested in.”
At that point, you’ll be paying more not for a difference in performance, but for whomever the fund manager is. And that’s not worth it.
That’s why strategies like the three-fund portfolio have attracted so many followers. They’re simple and give you as good of results as you can feasibly ask for over the long term. They can provide relatively easy access to decent reward.