The Dangers Of Overdiversification

By Joe Ponzio on June 29, 2007  |  5 comments

When the markets crashed in the early 2000s, Wall Street was quick to run to the television and tell America that investors were too aggressive and should have been more diversified. And yet, not a person in the world can tell you how much diversification you should have...or how much is too much.

A strategy to help reduce overall risk and volatility in a portfolio, diversification is the practice of buying a bunch of investments of differing types. Most diversification strategies have no regard for the quality of the investment or the price at which it is purchased because the generally accepted thinking is that you are better off being widely diversified than waiting for a great opportunity.

The problem with diversification is that investing is a zero-sum game-someone's gains are always offset by someone else's losses. It is impossible to make money owning an investment unless someone else (or many other people) loses that money. An example of this is a game of chess-it is impossible for both players to win.

If you were to own every investment in the world, you would earn exactly 0% because all of your gains would be offset by all of the losses in your portfolio. Though it is impractical to think you can own every investment in the world, the more diversified your portfolio becomes, the closer you come to earning a 0% return.

So, how diversified should you be? Why not concentrate your portfolio in a few truly wonderful investments? If you understand how businesses grow, how to value a business, and how to spot problems and opportunities, the thought of diversification for the sake of diversification becomes silly.

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