CFP Explains The Dangers Of Too Much Diversification In Your Portfolio

While most would agree that lacking diversity in your portfolio is a huge mistake, you might be surprised to learn that too much diversity can also be a problem. For those who might need a quick refresher, portfolio diversification involves spreading your investments across multiple types of assets (stocks, bonds, short- and long-term investments, etc.). By ensuring your overall portfolio includes elements across multiple avenues, you can better protect your investments from volatility in the market. Essentially, if one area or investment experiences a downturn, the rest of your portfolio could help to offset those losses. With that in mind, how you go about this diversification can vary widely depending on your individual preferences and how involved you like to personally be in your investments.

We spoke with Shinobu Hindert, CFP and author of "Investing Is Your Superpower," about the good and the bad of portfolio diversification. For starters, we asked Hindert where she thought new investors should start when it comes to managing and/or creating diversification in their portfolios. Hindert said, "For new investors, I recommend considering an allocation fund or using a robo-adviser. These options provide a balanced approach to diversification while giving you access to professional advice without the need to manage your investments daily."

While these generally affordable options can offer new investors the freedom of not having to be directly involved (and potentially feel overwhelmed), others might prefer a more hands-on approach. Let's dive into diversification, and how to find the right balance for your portfolio.

Despite the generally positive elements associated with diversifying your portfolio, there can still be some downsides to look out for, especially when it comes to potentially over-diversifying. Shinobu Hindert explained the big-picture problem. "Over-diversifying can spread your investments too thin," she said. "The strong performers in your portfolio can be offset by the weak performers. Your overall result could be mediocre as a result." According to industry experts, the sweet spot is about 20 stocks in a portfolio. In fact, in the textbook "Modern Portfolio Theory and Investment Analysis," researchers found that risk is reduced by 27.5% with a portfolio of 20 stocks (compared to a single-stock portfolio), but that additional stocks after 20 (up to 1,000) failed to offer significant additional risk mitigation.

Hindert also told us, "Another risk here is having a false sense of security because of the over-diversification. If most of your investments are correlated, meaning your investments move in the same direction as each other, during a market downturn, your investments may all decline." This is why, when it comes to diversification, it's important to prioritize stocks and/or industries that have little to no correlation to each other. Otherwise price volatility will still deeply affect your overall portfolio, regardless of how many stocks you may have in it. Finding the right balance of correlation can be especially important for investors. As Hindert said, "You want to have a balanced investment strategy that includes assets with varying correlations to effectively manage risk." (Read about how to prepare for a market correction.)

While finding the right balance of diversification can feel tricky at first, Shinobu Hindert offered some advice, saying, "The right mix between stocks, bonds and cash that someone should have in their portfolio is based on three main factors: current financial situation, tolerance to risk, and time the investment will be in the market." She added, "For example, if you're investing for retirement and it's 30+ years away, you may choose a mix of 80% stocks with a mix of different-sized companies as well as companies located in different regions and 20% bonds." Having a clear idea of what your investments are ultimately for, and the timeline attached to that, can help you better plan your portfolio.

Hindert also went on to explain just how accessible this information can be to find, noting "these optimal asset allocation portfolios are published by large financial institutions if you want to see this in more detail." Remember that it could also be worth discussing your portfolio options with a financial adviser (we have some tips on how to choose the right adviser for you). While it can be tempting to take financial advice from online sources (specifically, social media), it's important to remember that, as Hindert previously told us, your specific financial situation and risk tolerance should be key factors in your financial decisions. For that reason alone, social media advice might not be the best option (not to mention just how bad online financial advice can be).