Imagine you’re building a collection of items that are meant to keep your life secure. You start with the essentials, adding what’s necessary to protect you from the unexpected. But soon, you keep adding more and more items, thinking each will make you safer. Before you know it, you’ve created a mess of clutter and confusion. This is what over-diversification looks like in an investment portfolio. While spreading risk is smart, going too far can dilute your returns and make managing your investments unnecessarily complex. In this article, we’ll explore how to strike the right balance.
Am I An Over-Diversified Investor?
To understand whether you’re victim of over-diversification, you should first have a solid grasp on what an ideal, well-balanced and diversified investment strategy or portfolio looks like. Diversification is the equivalent of not putting all your eggs in one basket. By spreading your money across different investments—like stocks, bonds, and other assets—you reduce the risk of losing everything if one investment performs poorly. An example of a well-balanced portfolio might include a mix of 60% stocks, 30% bonds, and 10% cash or alternative assets. A critical goal of portfolio design is to match both the investor’s risk tolerance and long-term goals.
However, over-diversification happens when you add too many investments to your portfolio. An over-diversified portfolio might include multiple mutual funds that invest in the same types of assets, like several large-cap stock funds. With so many small positions, it becomes hard for any single investment to have a meaningful impact. Instead of lowering risk, it reduces your portfolio’s effectiveness.
The main issues? Diluted returns, higher costs, and more complexity. Too many assets can overwhelm your portfolio, making it harder to grow and manage efficiently.
Common Pitfalls Investor’s May Fall Victim To
Many DIY investors aim to reduce risk by diversifying, but they often fall into traps that do the opposite. These mistakes typically stem from misunderstanding how to properly balance a portfolio. Whether it’s choosing similar funds, making emotional decisions based on market trends, or holding too many small investments, these actions can clutter a portfolio and weaken returns. Let’s explore the three most common mistakes that lead to over-diversification and how they impact your investment strategy.
1. Owning too Many Similar Funds
Investors often buy multiple mutual funds, thinking they’re adding variety to their portfolios. However, many funds may hold the same or similar assets, such as large-company stocks. For example, imagine owning three different mutual funds, but all three invest mostly in large U.S. companies. Even though you own different funds, you’re still heavily invested in the same area, so your portfolio isn’t truly balanced. This doesn’t spread risk; instead, it creates overlap. So, even if you own multiple funds, your money is concentrated in the same types of investments, reducing the benefits of diversification.
“Diversifying just for the sake of adding more funds can easily undermine the goal of your strategy. Suppose your funds are essentially doing the same thing. In that case, you’ve only added complexity without the benefit of reduced risk,” explains Bambrah Walker, VP and Financial Advisor at Summit Retirement Advisors.
2. Emotional Buying and Selling
A friend tells you about a tech stock that’s skyrocketing, so you buy some without thinking about how it fits into your investment strategy. Later, you realize your portfolio is full of stocks that all react to the same market trends, leaving you vulnerable to big swings. Several weeks later, the tech stock dropped significantly, and you lost 6% of your assets in 24 hours.
While this example may be an extreme scenario, the notion behind the example remains the same: Emotions can easily cloud investment decisions. If you hear about a hot stock or fund performing well, it’s tempting to jump in without thinking it through. This leads to buying investments impulsively, rather than considering if they fit your long-term goals. The result? You end up with a cluttered portfolio filled with random investments that works for someone else, not you.
3. Too small or too many scattered assets
You invest small amounts in 75 different stocks, but each represents only 1% or 2% of your total portfolio. You hear on the news XYZ Company’s stock jumped in value and you’re ecstatic because you know you’ve purchased shares. You check your portfolio and notice there is barely any impact on your overall returns.
Investors might think more is better, but owning too many tiny positions means each one has little effect on your overall returns. Jon McCardle, President and AIF at Summit Retirement Advisors shared a case in which a client held numerous technology stocks at small weightings, a bond fund at 18%, and a 70% in an S&P 500 index fund. The portfolio was never rebalanced, resulting in poor diversification despite owning many different assets. “It’s one thing to think you know what to buy,” McCardle says, “but knowing when and how much is critical.”
Most DIY investors fall into these traps because they lack the tools, knowledge, or experience to see when their investments overlap. The fear of missing out drives them to chase gains, but this often leads to a scattered portfolio that underperforms. The good news is that avoiding these mistakes is possible with the right approach.
Avoiding Over-Diversification
As mentioned before, building a well-balanced portfolio is about quality over quantity. We believe the foundation of a successful investment portfolio begins with a clear investment strategy. Know your investment goals and understand how you would ideally like the strategy to work for you. Clear objectives and wants help you align your strategy to meet specific life goals instead of adding unnecessary assets.
Rather than trying to offset risk by over-diversifying, aim for a balanced portfolio that matches your comfort level, or what the industry calls “Risk Tolerance”. Risk tolerance is an essential component of an investment strategy that most individuals may not know how to identify. A financial advisor can also help assess your risk tolerance based on your unique situation.
Focus on quality, not quantity. “A well-balanced portfolio is not about quantity—it’s about the quality and impact each fund can have on your overall performance. Allocating 1% to 2% to a stock that grows significantly won’t move the needle for your portfolio,” Walker adds. “Concentrating on a few key investments with conviction can often yield better results than spreading yourself too thin.”
Over-diversification creates an illusion of safety but often leads to diluted returns and higher costs. By staying focused on your investment goals and regularly reviewing your portfolio, you can avoid the pitfalls of excessive diversification and ensure your strategy delivers meaningful results.
It’s important to recognize that understanding your risk tolerance can be challenging for DIY investors, and it’s perfectly okay to seek help from a financial professional. A trusted advisor can provide guidance, helping you cultivate a strategy that aligns with your goals and comfort level. Having the right approach can greatly impact your long-term financial well-being. Don’t hesitate to reach out for support to help ensure your portfolio is set up for success, especially when it comes to balancing risk and reward for the future.
Note: The information contained in this article is for educational purposes only and should not be relied upon as financial advice.
