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How Diversification Can Hurt Your Portfolio

As the saying goes, “don’t put all your eggs in one basket”. That may be the mantra for portfolio diversification…but it’s not just that you diversify…it’s how you diversify that matters. And there are a few common mistakes that can dampen your returns.

First, over-diversification can hurt your return. Owning too many stocks can do more harm than good. Most of the gains within a portfolio come from the first handful of stocks: owning a portfolio of 5 stocks can give you 71% of the diversification benefits of the market (according to landmark research by Elton and Gruber). And over-diversification can mean higher costs…the more securities you own, the higher the overall transaction fees.

Second, underdiversification can equally hurt your return. Owning too few stocks can result in missing out on winners… unless you happened to hold a ‘superstock’ that outperforms the market at exactly the right time. But the odds of consistently picking an outperformer as one of only a few stocks in a portfolio aren’t that good.

Third, a false belief that you are properly diversified is just as bad as being over or underdiversified. A study of private investors conducted by Kumar and Goetzmann, shows that misunderstanding diversification is very dangerous: on average, investors owned just 4 stocks…and those stocks were typically highly correlated, meaning the benefits of diversification were almost totally lost. The result: the average portfolio in the study underperformed the market by as much as 4% annually. Fourth, diversifying through mutual funds can eat into your return… if you are not careful. Hidden fees can diminish your overall return without you knowing it…so understand the fund and its expense ratio.

The lesson: don’t put all your eggs in one basket, but don’t divide your eggs among too many baskets either. And don’t put your eggs in a basket that costs too much… and don’t blindly assume that your eggs are divided up perfectly. Portfolio diversification is about more than just an old expression.

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