Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
In continuation of our 3-part discussion series on Risks to Investing, we talk about a single risk that many investors succumb to without realising it.
Yes, you read it right. It is possible to be over-diversified.
In general, it is common for most wealth managers to advise their clients on the benefits of diversifying their assets. It makes sense. The market is a fickle creature. And how different assets move in which direction can be unpredictable and at times, it would seem, inexplicable as well. Which is why diversification can help balance out market volatility to even out returns.
However, while investors might feel drawn to their diversification benefits, the sheer number of positions funds can hold is something many fund investors fail to appreciate, our Head of Research, Wendy Spires noted in a piece on risks and restrictions of funds.
But who can blame them? With funds holding sometimes 100 positions, their performance is at the mercy of a whole range of risk factors, not just over-diversification risk.
Yet, when it comes to risks to investing, over-diversification is a big one. As Artur Baluszynski, Head of Research at Henderson Rowe, pointed out in an earlier findaWEALTHMANAGER.com post here, “Sometimes you see different funds holding 40% of their portfolio in same four or five positions. So if you’re in UK Income funds, you’re likely to hold Vodafone and British American Tobacco in most of them; on the other hand, some managers hold around 100 positions across the market,” said Baluszynski.
So over-diversification can be hugely self-defeating and, if your funds are replicating each other’s positions, you can add concentration risk to the mix too.
But let’s not be too hard on ourselves.
When investing, and looking to maximise returns, it easy to forget that even with the best of intentions and the utmost vigilance we can overlook something so simple as over-diversification. So it’s best to look under the bonnet from time to time to readjust, rebalance, and remove if need be.
To read our previous discussion on risk to investing, please check out the “Roulette Risk – Big 5 Unknown Investment Risks”.
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