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Why Over Diversifying Your Investments Is Dangerous

Do you collect mutual funds? Unlike hobbyists who collect stamps, art or rare coins, investors who own a multitude of funds are not better off.

While diversification is important to any portfolio, owning too many funds can make investing more complicated that necessary.

One of my clients owned 16 different accounts, including an array of stock and bond mutual funds. In all, he had 56 mutual fund positions. Everyone should be well-diversified, but this client had missed that mark. He had a cluttered collection of investments that didn’t serve him well.

A lot of folks are in the same situation: Their finances are a hodgepodge. Good financial advisors bring order to that mess, and adopt a common-sense strategy for the long term.

Five years ago, the client, a doctor, came to me because he wanted to retire. His portfolio was sizeable, yet he had no idea what he owned or why. “I simply don’t understand what I have,” he said. “Will I have enough cash flow in retirement?”

I told him his concern was spot-on. I helped consolidate his holdings while greatly improving his diversification.

Here’s what’s wrong with owning too many funds and other investments:

Tracking them all is difficult. You should review all your monthly statements. Following 16 accounts can be a nightmare. Rebalancing when your circumstances change or funds shift in value is a challenge. Evaluating performance is nearly impossible. Fewer funds and accounts are much easier to handle.

Duplication is common. With so many funds aggregated haphazardly with no plan, you get a lot of overlap. My client had some funds that matched his Standard & Poor’s 500 index fund, except they cost more in annual fees. There’s no sense in paying for more of the same thing.

There’s little diversification, and risk isn’t reduced. Ideally, a portfolio is sufficiently balanced so that if one asset suffers, others offset its losses. A study by Morningstar, the investment research firm, shows that owning more than four randomly selected funds decreases risk very little. Only a small difference exists between holding four funds and 30.

Figuring out where to get cash in retirement is a chore. Once retirement begins, you need to decide which accounts should provide your cash flow. Consolidated accounts made this process much easier.

In my client’s case, around 80% of his portfolio was in stocks or equity funds. His portfolio looked like that of a 30-year-old, not a 70-year-old. All that stock exposure was too risky for a man his age. You need to safeguard the value of your assets to see yourself through retirement.

We switched him to a 50%-50% split between stocks and bonds. This gave the client the ballast of a solid fixed-income allocation, and also allowed him enough stock exposure to keep his net worth growing – thus increasing his chance of leaving a substantial bequest for his heirs. Stocks’ growth usually offsets inflation, which eats away at bonds.

Before he came to us, my client was driving with no road map. In assisting him, we dramatically simplified his financial life.

As with most things, in the world of financial planning, simpler is better.

Jason Lina, CFA, CFP is Lead Advisor at Resource Planning Group Ltd. in Atlanta.

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