Why buying too many stocks can be a downfall? When it comes to investing, spreading your money across many different stocks might seem like a smart move.
Camilo WoodJan 30, 2024236 Shares19634 Views
Why buying too many stocks can be a downfall?When it comes to investing, spreading your money across many different stocks might seem like a smart move. After all, it's a way to lower your risk, right? Well, not always. Sometimes, while it's true that diversification can help protect your investments, going overboard with too many stocks can hurt your chances of making big gains.
Diversification in a stock portfolio involves spreading investments across various companies, sectors, or even countries to mitigate risk. While it doesn't guarantee immunity from losses, most investment experts advocate for diversification as a prudent strategy for long-term financial goals. Numerous studies support its efficacy, with the core principle being the reduction of price volatility by investing in sectors or industries with low correlation.
The rationale is simple: different sectors don't always move in tandem, so by diversifying, you cushion against major drops. When some sectors struggle, others may flourish, balancing out the overall portfolio performance. However, it's crucial to recognize that diversification can't eliminate risk. While it can mitigate the risk associated with individual stocks (known as unsystematic risk), market risks (systematic risk) persist, affecting nearly all stocks. Despite this, diversification remains a powerful tool for managing investment risk.
Diversification boils down to having a variety of stocks in your portfolio, ensuring that if some companies stumble, others can compensate. For instance, during periods of turbulence like the tech sector's downturn in 2022, a diversified portfolio spanning multiple market segments offers protection when one sector falters.
However, it's essential not to overextend. While owning several dozen stocks is wise, going overboard isn't advisable. Stocks demand active monitoring; it's challenging to stay abreast of developments in 80 or 100 companies. Overloading your portfolio could lead to neglecting stocks that warrant attention, potentially resulting in holding onto underperformers when you should be considering divestment due to underlying company issues.
Determining the optimal number of stocks for your portfolio isn't a one-size-fits-all equation; it hinges on your willingness to conduct research. Each stock requires vetting before inclusion, meaning building a portfolio of 45 stocks entails researching each one individually.
For reference, the Motley Fool suggests owning a minimum of 25 stocks, with the average diversified portfolio typically ranging between 20 and 30 stocks. While aiming for 36 stocks isn't unreasonable, managing a portfolio of 75 could prove daunting.
Another avenue for diversification is incorporating ETFs (exchange-traded funds). Investing in an ETF allows you to access a basket of stocks with one purchase, streamlining your efforts. For instance, buying into an energy ETF eliminates the need to individually research numerous energy companies. ETFs are a prudent choice if you're unsure about your portfolio's diversification but already hold several stocks and wish to limit further additions.
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To cut through the marketing noise and better understand mutual fund offerings, Morningstar introduced categories such as "large-cap value" and "small-cap growth" that group funds with comparable investment holdings and strategies. These classifications help investors navigate the landscape and make informed decisions.
However, investing in multiple funds within the same style category can escalate costs, necessitate more extensive due diligence, and potentially diminish diversification benefits. By cross-referencing Morningstar's style categories with the funds in your portfolio, you can gauge whether you've inadvertently accumulated too many investments with overlapping risks.
Multimanager investment products, such as funds of funds, offer small investors a convenient route to diversification. However, for individuals with larger portfolios nearing retirement, diversifying directly among investment managers may be more prudent. When evaluating multimanager products, it's essential to consider their diversification benefits against drawbacks like lack of customization, high costs, and diluted due diligence processes.
Questioning whether it's truly beneficial to have a financial advisor oversee an investment manager who, in turn, oversees other managers is crucial. It's noteworthy that a significant portion of the funds involved in Bernard Madoff's notorious fraud was funneled to him indirectly through multi-manager investments like funds of funds or feeder funds. Many investors in these funds were unaware that their investments were ultimately tied to Madoff's scheme, buried within the complexity of a multimanager diversification strategy.
Privately held, non-publicly traded investment products are often praised for their price stability and diversification advantages compared to their publicly traded counterparts. However, while these "alternative investments" may indeed offer diversification, their risks could be downplayed due to the intricate and irregular valuation methods used.
Many alternative investments, such as private equity and non-publicly traded real estate, rely on estimates and appraisals rather than daily market transactions to determine their value. This "mark-to-model" valuation approach can artificially smooth a product's return over time, a phenomenon known as "return smoothing."
It's crucial to avoid falling for the effects of intricate valuation techniques on statistical diversification measures like price correlations and standard deviation. Non-publicly traded investments may carry more risk than is apparent and demand specialized expertise for analysis. Before investing in such products, request that the individual recommending them illustrate how their risk-reward profile fundamentally differs from publicly traded investments in your portfolio.
Understanding the pitfalls of over-diversification requires laying a foundation of why diversification is typically viewed as a prudent strategy in investing. Historically, investors have been advised to spread their investments across different assets to mitigate risk.
This approach aims to reduce the impact of any single asset's poor performance on the overall portfolio. However, while diversification is a valuable risk management tool, it can be taken too far.
Firstly, it's essential to establish the primary goals of diversification, which include lowering portfolio volatility and preserving capital. By investing in a variety of assets with non-correlated price movements, investors aim to cushion against downturns in any particular market or sector.
This principle is grounded in the idea that different assets perform differently under various economic conditions. For instance, when stocks decline, bonds or real estate investments may hold their value or even appreciate, thereby offsetting losses.
However, over-diversification occurs when investors spread their investments so thinly across numerous assets that the benefits of diversification diminish. This phenomenon can occur for several reasons:
Diminished impact -As the number of holdings increases, the impact of any single asset's performance on the overall portfolio diminishes. While this may seem beneficial in reducing risk, it also caps the potential upside since outstanding performers have less influence.
Increased complexity -Managing a large number of investments becomes increasingly complex. It requires more time and resources to monitor each asset's performance, leading to decision paralysis and potentially missed opportunities.
Higher costs -Maintaining a diversified portfolio incurs costs such as transaction fees, management fees, and potentially taxes. With too many holdings, these costs can eat into returns and erode the portfolio's overall performance.
Lack of focus -Over-diversification can lead to a lack of focus on high-conviction investment ideas. Instead of concentrating on a few carefully chosen assets, investors may dilute their attention across numerous holdings, potentially missing out on significant opportunities.
Underperformance -Research suggests that excessively diversified portfolios often underperform more focused ones over the long term. This underperformance can be attributed to the challenges mentioned above, including diluted returns, increased complexity, and higher costs.
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Diversifying your portfolio stands out as a top strategy for mitigating overall risk. By spreading investments across various companies, industries, and geographic regions, you effectively eliminate non-systemic risk, leaving behind only the inherent risk of stock market investment.
A well-diversified portfolio, ideally spanning companies, industries, and geographies, tends to show consistent long-term growth while exhibiting reduced volatility. The performance of other holdings in a diversified portfolio serves to counterbalance the effects of specific company failures, industry downturns, or economic difficulties in particular regions.
Despite the benefits of diversification, managing a large stock portfolio can pose challenges, including administrative overhead and potential trading costs. For those who prefer to avoid selecting individual stocks, investing in exchange-traded funds (ETFs) presents an attractive alternative. ETFs offer instant diversification by holding a basket of stocks, with some ETFs containing hundreds of stocks in their portfolios.
If you buy too many stocks, you might have a difficult time keeping up with all of them. That could put you at risk of hanging onto stocks you should be considering dumping due to issues with the companies behind them.
Issuing too much stock can cause a problem for any company. It can become a reason for the dilution of ownership in the company. Excessive supply of stock can exceed the actual demand for the stock, which depresses the stock price in the financial market.
Here's the number of stocks you should own in portfolios, according to professional money managers. Portfolio concentration is risky. Targeting 20 to 30 stocks is common advice, but many pros own more. Pros tend to own lots of stocks, but they weigh them unequally.
Diversification is like ice cream. It's good, but only in moderation. Answering the question, "Why buying too many stocks can be a downfall?" we should know that the common consensus is that a well-balanced portfolio with approximately 20 unrelated 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.