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In the realm of investment, diversification is universally acclaimed as the cornerstone of risk management and portfolio optimisation. This principle, encapsulated by the adage "don't put all your eggs in one basket," has long governed the strategies of individual investors and financial advisors alike, championing the spread of investments across various asset classes to mitigate risk and enhance returns.
However, the burgeoning practice among Investment Financial Advisors (IFAs) to excessively diversify investment portfolios by allocating assets across a myriad of funds, which in turn invest in dozens, if not hundreds, of stocks, warrants a critical examination.
This trend towards over-diversification has sparked a nuanced debate, prompting this article to delve into a synthesis of academic research and empirical evidence. The aim is to argue that beyond a certain threshold, diversification ceases to add value and may, in fact, precipitate underperformance, challenging the conventional wisdom that more diversification is invariably better.
The Concept of Optimal Diversification
The seminal work by Harry Markowitz on portfolio theory in 1952 laid the foundation for modern investment strategies, introducing the concept of diversification as a method to optimise the risk-return trade-off in a portfolio.
Markowitz's groundbreaking theory posits that an investor can achieve optimal diversification by carefully selecting securities that are not perfectly correlated, thereby reducing the portfolio's overall risk without proportionately diminishing its expected return. This concept has profoundly influenced portfolio management strategies, emphasising the balance between risk and return.
However, the application of Markowitz's theory in practice, particularly by IFAs, often leads to what is termed as "over-diversification." This phenomenon occurs when a portfolio holds a large number of assets to the point where the marginal benefit of adding an additional asset in terms of risk reduction is negligible or even negative.
The pursuit of over-diversification, while intended to minimize risk, can inadvertently lead to a plateau in the risk-reduction benefits, marking a departure from the principle of optimal diversification.
The Drawbacks of Over-Diversification
The critique of over-diversification is supported by various studies and empirical evidence. A pivotal study by Evans and Archer (1968) demonstrated that the benefits of diversification diminish significantly beyond 10 to 20 securities, with little additional risk reduction achieved beyond this point.
This finding suggests that the sprawling portfolios often recommended by IFAs may indeed be counterproductive, offering a compelling argument against the unchecked expansion of portfolio assets.
Moreover, over-diversification can lead to a dilution of returns. As portfolios become increasingly diversified, their performance tends to gravitate towards the market average, potentially foregoing the higher returns that more concentrated portfolios might capture through astute selection and timing.
This convergence towards mediocrity not only undermines the potential for above-average returns but also challenges the very rationale for active portfolio management.
Additionally, over-diversification increases the complexity and the management costs of portfolios. Each additional investment not only adds to the direct costs, such as management fees and transaction fees, but also complicates the task of portfolio monitoring and rebalancing.
This escalation in complexity and costs can significantly erode net returns, diminishing the financial benefits of diversification. The work of Sharpe (1991) highlights the adverse impact of increased management costs on portfolio performance, underscoring the importance of maintaining a balance between diversification and cost efficiency.
Conclusion While diversification remains a fundamental principle of investment strategy, the practice of over-diversification presents a paradox. It challenges investors and financial advisors to reconsider the conventional approach to portfolio diversification, advocating for a more measured and strategic application of this principle.
By recognising the limitations and potential drawbacks of over-diversification, investors can better navigate the complexities of portfolio management, striving for an optimal balance that maximises returns while managing risk effectively.
Alpesh Patel OBE
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