Everything in life requires balance, and this includes the investment category too. Diversification can help limit devastating losses without damaging potential returns, but this benefit can be attained with a simple mutual fund lineup: a fully diversified portfolio can be achieved with just 3 to 10 solid options. Beyond that level, adding more funds is probably hurting instead of helping the situation. Why is this? There are various moving parts involved in the proper design and management of a portfolio, including striking the right balance between potential risk and reward, ensuring that each fund manager is doing their job, and controlling costs and taxes. As the total number of mutual funds and overall complexity rises, other important aspects of investment management are hampered, which means that overdiversification is both unnecessary and harmful to the well-functioning investment program.
More spice isn’t always nice
A good analogy for this case is a novice cook who, upon hearing how important spicing is in cooking, overloads all her dishes with dozens of different varieties. Each spice serves a specific role in a cook’s repertoire, and adding the right ones in the correct measurements is what ensures the best results. More doesn’t equal tastier, and usually, the opposite is true. Most foods can be prepared to excellent effect with just a few flavorings, and complicating things will often lead to a clash of flavors. Loading up a pantry with additional exotic spices also means that freshness will go down (as each sit on the shelf for longer), costs will go up (as smaller quantities are purchased), and headaches and mistakes increase as the complexity of the kitchen does. In a similar vein, you will generally get better results by following a transparent and streamlined investment “recipe” tailored to your needs.
Portfolio risks hidden in plain sight
Diversification is about using different things to balance all the individual components, sort of like the sweet and sour contrasts of a well-crafted food. But to have multiple forms of the same risky assets, like putting three brands of sugar into a cake, is an effort that adds nothing extra. So too, having many risky funds that overlapped provided a false sense of security about an inappropriate level of risk which would have been easily identified with fewer investment holdings.
Buried costs and taxes
Monitoring the performance of each fund used in a portfolio is easy when the investor sticks to one or two funds in each category, not when there are 10. The review also showed that the average cost of funds was high and its tax efficiency was poor. The combined drag of under-performance, high fees, and taxes was significantly slowing the potential growth despite its elevated risk. This investment plan is clearly not a good “meal,” and the “cook” should be fired!
Follow a recipe, not a spice salesman
With some practice, most people can spice basic foods on their own or follow a tried and tested recipe for foods that are more complicated. One thing they don’t do is ask a spice salesperson to send them the most popular spice and blindly add it to their pots. There are plenty of good mutual fund options out there, and it’s never been easier to whip up a great investment portfolio ranging from sweet (conservatively stable) to spicy (aggressively risky). But whatever your taste, you need to either follow a recipe or hire a cook.