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Cost of Diversification

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  • Costs of diversification, can you be too diversified. What are the risks of being too diversified

Risks and costs to diversification, which need to be balanced with the potential benefits:

  • Not reducing the risk
  • Adding assets which are exposed to the same risks, with very similar outcomes from those risks, does not reduce the risk exposure of your portfolio
  • You think you are diversified, when you are not. In some cases you might have increased the risk, as the added asset could have a greater exposure to the risk.
  • Adding assets which have high correlation with the current portfolio does not reduce the risk very much
  • Costs of diversification
  • Diversification incurs costs. These costs need to be weighed against the benefits of risk reduction. Diversification costs include: transaction costs, cost of monitoring, tax costs due to more frequent trading
  • lower returns as inferior assets are added to the portfolio
  • Assuming that a portfolio is started with those assets which the investor considers to be the best (on a risk/return basis), each additional asset will be inferior to all the existing assets in the portfolio. This reduced return is a cost of diversification. At some point reduced return from additional diversification will exceed the benefits of that diversification.
  • Significantly reducing the positive outcomes
  • If you hold too many assets, the proportions of each are so low, that if one of them becomes a major success, it will have very little impact on your overall return. While holding many assets can mean that you have very little loss from a mistake, you also ensure very little gain from a success.
  • Thinking that owning many assets means diversification and risk reduction
  • Naïve diversification is the belief that just by owning many assets you are diversified, and have reduced risk exposure. Assets can have different correlation in good times than they do in bad times. If there is high correlation when negative events occurs, all portfolio assets would lose together. This is not diversification, this is convergence. Risk has not been reduced.

The common consensus is that a well-balanced portfolio with approximately 20-30 stocks diversifies away the maximum amount of market risk. Owning additional stocks takes away the potential of big gainers significantly impacting your bottom line, as is the case with large mutual funds investing in hundreds of stocks. According to Warren Buffett: "wide diversification is only required when investors do not understand what they are doing". In other words, if you diversify too much, you might not lose much, but you won't gain much either.

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