One problem that we see over and over again in both institutional and individual portfolios is over-diversification. That is, portfolios with too many asset classes and or fund managers.

Many investors seem to believe that there’s no such thing as too much diversification. The reality is far more nuanced. Like most things in investing, diversification is a trade-off.

Too little diversification, and a mistake or bad luck can do serious damage to your portfolio. To much diversification, and your wins are such a small part of your portfolio that they make no difference to the overall result.

How much diversification is enough? David Swensen, Chief Investment Officer of the Yale University Endowment, and one of the most successful long-term investors in the world answers this question in his book Pioneering Portfolio Management:

While market participants disagree on the appropriate number of asset classes, the number should be small enough so that portfolio commitments make a difference, yet large enough so that portfolio commitments don’t make too much of a difference. Committing less than 5 percent or 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Committing more than 25 percent or 30 percent to an asset class poses the danger of overconcentration. Most portfolios work well with around a half a dozen asset classes.

For example, it’s quite common to see portfolios with small allocations (i.e. 2-3%) to emerging market equities. In 2017, Emerging Market shares out-performed developed market shares by 13.77%. But a 3% holding would have only contributed 0.41% to the overall fund return. Conversely, in 2015, emerging market under-performed developed market shares by -15.80%. In this case, a 3% allocation would have detracted -0.47% from the overall result.

As Swensen points out, allocations of this size don’t contribute much (aside from complexity and cost). Why do people build portfolios this way? We’ll come back to that question shortly. First, we need to consider risk.

You might be thinking, aren’t emerging market shares risky? Isn’t it therefore prudent to only invest a small amount? Maybe. But it’s worth pointing out that the MSCI Emerging Markets Index contains 845 stocks across 24 countries.

Contrast this with the Australian share market, where the big four banks make up approximately one quarter (i.e. just over 24%) of the market. A typical balanced portfolio will hold 20-30% in Australian shares. This means that it would hold 5-7.5% in just four companies. All of them in one country and all exposed to the same economic driver (the Australian housing market). Portfolios focusing on income will often hold even more in these four banks.

So, it may not be true that a larger allocation to emerging market shares is risker (from a fundamental perspective) compared to other allocations that currently feature in most portfolios. The point isn’t to argue in favour of investing more in emerging market shares per se. It’s to highlight why small allocations make little difference to portfolio outcomes.

Why create portfolios this way? Institutions often herd around market benchmarks and hold similar allocations to their competitors. They do this to minimise the chances that they’ll underperform. Guess what, as Swensen points out, this also minimises the chances that their clients will out-perform.

Individual investors are often given advice recommending over-diversification. Here are some of the reasons why we think this happens:

  • Advisors may feel that its difficult to justify their fees if the recommend simple portfolios.
  • Most financial advice is transactional (i.e. we really like high yield bonds at the moment, why don’t we allocate 2% of your portfolio?) rather than strategic (i.e. the role played by each investment in helping you meet your long-term objective).
  • The investment objective, beliefs and strategy are unclear. There is no investment policy statement.
  • Some advisors make the claim that a part of their value add is that they offer access to new, high-performance, alternative or exotic opportunities that investors may otherwise miss out on.

But these strategies are risky for an advisor for two reasons. Firstly, they may actually be riskier. Secondly, the client is less likely to understand what they are and therefore more likely to pull the plug at the first sign of poor performance.

Advisors need to balance the trade-off between a desire to include novel or unique strategies that they can pitch to clients (i.e. we can give you access to the latest and greatest investment opportunities) and the risk of disappointing performance. They do this by investing just enough to make things interesting but not enough to anger the client when things don’t live up to expectations.

We saw a portfolio the other week where the advisor had recommended that the client hold 1-2% positions in a wide selection of different active investment funds. We call this a “stamp collection”. The positions had built up over time, probably as a result of years of transactional advice.

Let’s assume that the client invested 1% of their portfolio in an active investment fund that beats their benchmark by 5% per annum (very hard to do). That investment has only added 0.05% (1% × 5%) to the portfolio relative to what the client would have earned using a simple low-cost index fund.

What if the other funds in the portfolio under-perform?  The extra return from the winning fund is unlikely to offset the performance of underperforming funds.

The result is that the client is left with a complicated and expensive portfolio that they don’t understand. Worst of all, they also end up with disappointing results.

Active management can add value. But it needs to be used appropriately. Portfolios need to be constructed in such away that the potential benefits of active management aren’t diversified away.