How Much Diversification in Your Portfolio Is Too Much? | Farm Bureau Financial Services (2024)

FAQs

How much diversification is too much? ›

There's no absolute cutoff point that distinguishes an adequately diversified portfolio from an over-diversified one. As a general rule of thumb, most investors would peg a sufficiently diversified portfolio as one that holds 20 to 30 investments across various stock market sectors.

A classic diversified portfolio consists of a mix of approximately 60% stocks and 40% bonds. A more conservative portfolio would reverse those percentages. Investors may also consider diversifying by including other asset classes, such as futures, real estate or forex investments.

It is a portfolio approach that tries create a portfolio that is as diversified as possible. In particular, the strategy tries to maximize the diversification ratio. As such, the maximum diversification approach is a risk-based allocation approach that does not take into account expected returns.

Over diversification is possible as some mutual funds have to own so many stocks (due to the large amount of cash they have) that it's difficult to outperform their benchmarks or indexes. Owning more stocks than necessary can take away the impact of large stock gains and limit your upside.

A good diversification strategy can help investors reduce the risk of owning individual stocks, but it is possible to have too much of a good thing. Over-diversification can end up reducing a portfolio's returns without meaningfully reducing its risk.

It can help you increase your revenue, reduce your dependence on a single source of income, and create a competitive advantage. However, diversification also comes with some risks, such as higher costs, complexity, and uncertainty.

A diversified portfolio should have a broad mix of investments. For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds. Meanwhile, others have argued for more stock exposure, especially for younger investors.

What Are the Rules of Thumb for Developing a Diversification Strategy? First, set aside enough money in cash and income investments to handle emergencies and near-term goals. Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds.

Most sources cite a low-risk portfolio as being made up of 15-40% equities. Medium risk ranges from 40-60%. High risk is generally from 70% upwards. In all cases, the remainder of the portfolio is made up of lower-risk asset classes such as bonds, money market funds, property funds and cash.

A high-level rule of thumb for avoid high levels of concentration is that a single stock should not make up no more than 5% of the overall portfolio. This is known as the 5% rule of diversification.

What is the best example of portfolio diversification? ›

Portfolio diversification is essentially the act of investing in a range of asset types. For example, as opposed to only investing in stocks, a diversified portfolio would consist of a mixture of stocks, bonds, property, and precious metals.

Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories. Unsystematic risk can be mitigated through diversification, while systematic or market risk is generally unavoidable.

Financial-industry experts also agree that over-diversification—buying more and more mutual funds, index funds, or exchange-traded funds—can amplify risk, stunt returns, and increase transaction costs and taxes.

Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.

Asset Diversification

of more than 5% cannot in aggregate exceed 40% of the fund's assets. This is known as the “5/10/40” rule. There are certain exceptions for government issued securities and for index tracking funds.

Holding too many ETFs in your portfolio introduces inefficiencies that in the long term will have a detrimental impact on the risk/reward profile of your portfolio. For most personal investors, an optimal number of ETFs to hold would be 5 to 10 across asset classes, geographies, and other characteristics.