The benefits of a well diversified investment portfolio can’t be overstated. When properly executed, diversification becomes the shock absorber of a portfolio, greatly reducing the risk of investment losses. But what many investors fail to recognise is that there is a point at which the benefits of diversification stop reducing risk and instead start eating away at investment returns.
How much diversification is enough? Investors have been asking this question for generations and the issue has been the subject of many academic studies. With respect to equity investing, it’s well settled that the optimal portfolio should contain anywhere from 15 to 50 well diversified individual stocks. There is a point at which adding additional stocks to a portfolio doesn’t meaningfully reduce risk, but it does reduce your potential rewards.
We recently reviewed a decent sized profit sharing plan for a small medical practice. Their equity allocation comprised of 24 different actively managed mutual funds. Just for kicks I decided to figure out how many underlying stock positions were represented by the 24 mutual funds. They had an ownership interest in an astonishing 5,071 different equity positions (granted there is likely a fair amount of overlap, which doesn’t help matters).
As for the 24 mutual funds, they were diversified across every conceivable equity investment style – it looked like someone just went down an investment style checklist and checked off all the boxes. According to their adviser, the strategy was to not just reduce risk through diversification but also to reduce volatility. Timeout. We’re talking about an actively managed portfolio of actively managed mutual funds (a bad idea in and of itself, but we’ll revisit that another day). Active managers get paid to turn volatility into investment gains, volatility is the lifeblood of active managers. This underlying investment strategy was doomed right out of the gate, it never had a chance.
Needless to say, the investment performance of the plan was dismal. Adding insult to injury, I broke the news to the trustees that when all the fees they paid were added up, they actually paid Wall Street more in fees last year than their account generated in gains. Chalk up another one for fee-based accounts aligning investors’ interests with those of the provider.
Financial services firms push these “paint by numbers” over diversified actively managed equity strategies for a very simple reason – equity related products and services carry the highest profit margins for these firms. By smoothing out volatility and making equity investing less risky, investors are more likely to view the equity market as a savings vehicle. But by reducing the risk and volatility to something that resembles a bank CD, these firms are cannibalising investors’ returns. In fact, these doctors would have been way ahead of the game had they been fully invested in bank CDs last year.
This kind of mindless over diversification has become so standard fare in the investment world that it’s no wonder that, according to Morningstar, only 17% of large cap equity mutual funds beat their benchmark last year. Most investors who suffer with these portfolio nightmares tell us that they would be thrilled if they could just get index returns, which begs the question, why don’t they just index? We guess it’s a testament to the power of Wall Street marketing.
Are you over diversified? Has your adviser preached the virtues of a low volatility equity strategy? If so, you may want to start asking what the current bank CD yields are or consider a low cost index fund. If it’s real equity returns you want, you’ll need to take some risk. Buckle up, it’ll be a bumpy ride and it’s not for everyone, but in the end you should enjoy the rewards.