Are your retirement investments too diversified? | Smart change: personal finance

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(Ryan Sze)

Diversification is arguably the most crucial concept in finance. Ray Dalio, the founder of hedge fund giant Bridgewater Associates, calls it “the holy grail of investing.” Harry Markowitz, the pioneer of modern portfolio theory, celebrates diversification as “the only free lunch in finance” – the only way for investors to reduce portfolio risk without sacrificing return.

While the importance of diversification is clear, its downsides are much less palpable – and easy to miss. Is this really a free lunch? Is it possible to have too many good things and be too diverse? Do you really need to own the entire market? Let’s find out.

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“Diworsification” – being too diverse

Unfortunately, it turns out that it may be possible to have too many investments in your wallet.

In his 1989 book “One Up on Wall Street”, Peter Lynch, legendary investor and head of the Fidelity Magellan Fund, expresses his contempt for over-diversification. He calls this “diworsification” – and notes that beyond a certain point, maintaining additional investments in a portfolio can lead to worse results.

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Disappointingly, this happens because diversification is not immune to the law of diminishing marginal returns – the idea that the diversification benefit provided by an investment diminishes with each additional contribution.

For example, while adding another issue to a portfolio of four stocks will do wonders for portfolio diversity, the 50th or 100th stock will do next to nothing – or could even hurt the portfolio – since the maximum advantages of diversification have already been acquired.

However, over-diversification is not necessarily detrimental to the performance of the portfolio. While adding too many names to a portfolio may be sub-optimal, an over-diversified portfolio is always better than an under-diversified one; while the first risks underperforming, the second risks ruining.

So if you want to avoid both over-diversification and under-diversification, where is the right place? What is the optimal number of farms to have?

How many investments are enough?

Typically, you need 10-30 stocks in a portfolio to be properly diversified, although the exact number is up for debate.

Value investors like Benjamin Graham have suggested that 15-30 stocks is sufficient, while Fisher and Lorie (1970) found 32 randomly selected, equally-weighted stocks to be a great option.

However, critics like Surz and Price (2000) argue that good diversification is not just a question of number stocks in a portfolio – it’s also about how accurately and consistently this portfolio tracks the performance of the broader market – and note that even 60 stocks is not enough to diversify the tracking risk. Other critics, such as Bernstein (2000), go even further, arguing that “the only way to really minimize the risks of owning stocks is to own the whole market”.

Ultimately, there is no real consensus on the perfect number of stocks to have in a portfolio, and what one investor sees as a properly diversified portfolio may be too risky for another. Like many things in investing, the “optimal” number of investments to hold is the number that best meets your needs. staff risk and return objectives.

So, do you have to own the entire market?

If you want the assurance that you’ll own a fraction of every publicly traded company – everything from the next Apple (NASDAQ: AAPL) and Netflix (NASDAQ: NFLX), with every dying company and zero – then it may be a good idea to buy a total market fund, like the one from Vanguard (NYSEMKT: VTI) – for full coverage.

At the same time, there are pragmatic reasons for holding fewer stocks. If you only have 15 names, you can afford to browse 10-K, listen to earnings calls, and read MD&A for each company in your portfolio – something that is impossible to do if you even own 150 companies, not to mention the 505 components. the S&P 500 or the 3,000+ publicly traded companies in the United States.

And frankly, the S&P 500 index funds aren’t very diversified anyway. Because the S&P 500 is a capitalization-weighted index, companies with a larger market capitalization are more heavily weighted. As a result, the top five holdings of the S&P 500 make up almost 21% of the index, and the top ten constituents make up almost a third.

If you’re looking for greater diversification, owning an equally weighted index fund – or evenly weighted a limited selection of hand-picked companies – may be a better choice. As long as you are smart and careful about investing your money, you can enjoy a well-funded retirement – free lunch or not.

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