A bundle more emails from people who entrusted their pensions to their IFAs and wealth managers only to find, in one case, a mere 3% rise in 10 years. Another had 20% in 10 years! Shocking. The Nasdaq was up 55% last year.

In the realm of investment, diversification is universally acclaimed as the cornerstone of risk management and portfolio optimization. The dictum "don't put all your eggs in one basket" has long governed the strategies of individual investors and financial advisors alike. However, the burgeoning practice among Investment Financial Advisors (IFAs) to excessively diversify investment portfolios by allocating assets across a myriad of funds, which in turn invest in dozens, if not hundreds, of stocks, warrants a critical examination.

This article delves into the nuanced debate of over-diversification, presenting a synthesis of academic research and empirical evidence to argue that beyond a certain threshold, diversification ceases to add value and may, in fact, precipitate underperformance.

The Concept of Optimal Diversification

The seminal work by Harry Markowitz on portfolio theory in 1952 laid the foundation for modern investment strategies, introducing the concept of diversification as a method to optimize the risk-return trade-off in a portfolio. Markowitz's theory posits that an investor can achieve optimal diversification by carefully selecting securities that are not perfectly correlated, thereby reducing the portfolio's overall risk without proportionately diminishing its expected return.

However, the application of Markowitz's theory in practice, particularly by IFAs, often leads to what is termed as "over-diversification." This phenomenon occurs when a portfolio holds a large number of assets to the point where the marginal benefit of adding an additional asset in terms of risk reduction is negligible or even negative.

The Drawbacks of Over-Diversification

The critique of over-diversification is supported by various studies and empirical evidence. A pivotal study by Evans and Archer (1968) demonstrated that the benefits of diversification diminish significantly beyond 10 to 20 securities, with little additional risk reduction achieved beyond this point. This finding suggests that the sprawling portfolios often recommended by IFAs may indeed be counterproductive.

Moreover, over-diversification can lead to a dilution of returns. As portfolios become increasingly diversified, their performance tends to gravitate towards the market average, potentially foregoing the higher returns that more concentrated portfolios might capture through astute selection and timing. This effect was highlighted by Malkiel, who argued that the excessive diversification could prevent investors from outperforming the market, essentially reducing the skill element in portfolio management to a negligible factor.

Additionally, over-diversification increases the complexity and the management costs of portfolios. Each additional investment not only adds to the direct costs, such as management fees and transaction fees, but also complicates the task of portfolio monitoring and rebalancing, potentially eroding net returns.

The Case for Strategic Diversification

The counterpoint to over-diversification is not under-diversification but strategic diversification. This approach involves selecting a relatively limited number of investments that are sufficiently diversified across different asset classes, sectors, and geographies but are also aligned with the investor's risk tolerance, investment horizon, and financial goals. The essence of strategic diversification lies in the quality of choices rather than the quantity, focusing on depth of analysis and potential for value addition rather than sheer volume.

In conclusion, while diversification remains a fundamental principle in investment strategy, there is a compelling case against over-diversification. The empirical evidence suggests that beyond a certain threshold, excessive diversification does not significantly reduce risk but can lead to underperformance and increased costs. Investors and IFAs alike should heed the lessons of academic research and empirical evidence, favouring strategic diversification that emphasizes quality over quantity. As the landscape of investment continues to evolve, the ability to discern the optimal level of diversification will remain a critical skill for achieving superior investment outcomes.

Alpesh B Patel OBE

www.campaignforamillion.com

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