What Is over-Diversification?
Over-diversification occurs when an investor puts their money into too many investments. This could be too many investments of the same type or too many as in the quantity of investments that are in the portfolio. Diversification of a portfolio is spreading out a percentage of the money so that a portion of the portfolio contains stocks, bonds, mutual funds, certificates of deposit and other appropriate investments. Diversification creates the proper balance in the portfolio to reduce risk, while over-diversification offsets the balance and increases the risk.
According to financial experts, a properly diversified portfolio contains 15 to 30 different types of investments. Over-diversification occurs when the investment portfolio contains more than 30 different types of investment vehicles. While experts emphasize the importance of diversifying investments, most agree that there is a point where diversifying no longer provides the benefit of less risk. By spreading out investments among too many different investment vehicles, it adds a layer of risk because not all the products can be given an adequate amount of research and attention. Any savvy investor knows that an investment should be researched and followed to track its success or failure.
There are signs that indicate when a portfolio is not properly diversified, beyond the fact that the portfolio contains more than 30 different types of investments. The first sign is when the mutual funds in the portfolio contain a lot of the same investments. Mutual funds are a combination of stocks, bonds and other investments, so if the mutual funds in the portfolio have a lot of overlap, then too much diversification is present.
Over-diversification can also occur across different types of investment accounts. For example, if an investor has similar or the same investments in his personal investment portfolio and all of his retirement savings accounts, then his investments are not diversified enough to minimize risk and maximize the returns on the investments.
Another sign of over-diversification is when a portfolio holds a lot of privately traded investments. While it is fine to own some privately traded stocks, again there should be a balance between the private and publicly traded stocks in the portfolio. This is in addition to the other types of investments in the portfolio as well.
Over-diversification can be more of a problem than a help to the investor and the investment portfolio. The primary problem with over-diversification is that it may give an investor a false sense of security, putting him at risk of taking a big loss. While proper diversification does not eliminate risk, over-diversification puts the portfolio at a greater risk for losses, or rather, it prevents the investor from focusing on putting together a properly diversified portfolio that has a higher potential to be profitable.
Diversification can also refer to product diversification that businesses engage in. It's also possible for businesses to over-diversify their products. The same issues apply to product over-diversification. The business may not be able to develop and promote each product as needed.
The other problem is that consumers may be unhappy with the additional products that the business has started producing. They may lose trust in the business and stop purchasing even the original products that the business became known for.
So over-diversification, in all sense of the word, is bad.
@stoneMason-- Diversification is actually fairly straight-forward and easy to understand.
Diversification is good but naturally, over-diversification is not. Generally, the more the investments, the more difficult it is to keep track of how each is doing. And like the article said, investing in a lot of the same type of investments does not serve the purpose of reducing risk. If one type of investment is affected negatively and an investor has many, this might mean that losses in ten or more investments at the same time.
It's difficult to recover from such losses. So investors need to keep a balance and invest in different types of things, without the number of investments going above thirty.
I didn't realize that it's possible to over-diversify. I know that diversification is a good thing because it gives the investor more things to fall back on in case some of the investments turn out to be non-profitable.
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