Under and Over Diversification

This brings up a new issue concerning diversification. Clearly, the best-known problem is underdiversification, a condition in which you are exposed to too much risk in your portfolio because your holdings are too similar and subject to the same market forces. Equally destructive is the opposite, or overdiversification, when you have capital spread out so broadly that overall returns are mediocre and, worst of all, below the market average.

If you overdiversify, meaning you spread your risks around to too many different stocks, you cannot beat the market average.
This is a problem faced by mutual funds, especially very large funds. They are required to limit their holdings in any one company, so they have to buy many different stocks. As a result, many are overdiversified. As a consequence, most mutual funds report results lower than the popular indexes by which the markets are measured. Only one out of six funds performed better than the bull market of the 1990s (that's only 42 out of 258 managed equity funds examined). And the average margin by which those beat the averages was very slim. (These funds were measured against the well-known S&P 500 Index.)

Key Point

It surprises some people to hear that most mutual funds have done worse than the market averages. This happens for many reasons, among them the need to overdiversify.

A more recent study, from 2004 through 2008, revealed that 66.21 percent of all managed stock funds in the United States reported results worse than the overall market (measured against the S&P Composite 1500 Index).

The overall report of 66.21 percent of all funds means that only about one-third of funds outperformed the overall market. This is due to overdiversification as one important factor in the outcome. In selecting a mutual fund for those who decide to choose that route, past performance is important but so is asset size.

Diversifying with mutual funds might seem a logical and easy step. But be aware that smaller funds have greater flexibility than extremely large ones and can move money around more easily.

Buying funds is one way to diversify within the stock market. You can mix directly owned stocks with shares of mutual funds and ETFs. You can also mix between value investments and speculation, as well as stocks in between. Volatility levels is a sound test of market risk, so diversifying by levels of volatility is one final way to spread capital around.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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