Moderately Risky?

Can you have too much diversification?

Conventional wisdom says no. If diversification reduces risk, then the benefit of owning 100 stocks should be twice that of owning 50 stocks. After all, in an equal-weighted portfolio each stock—at 1%–is only half as important to the portfolio at 100 stocks than it is at 50 stocks.

But that isn’t the way the math works. When you measure the risk of over-concentration, your benefit comes from what you don’t own, not what you own. That is to say, if something goes wrong in a company, I benefit to the extent that I don’t own that company. Suppose I own five stocks in equal proportions. Each stock represents 20% of my portfolio. If one of those companies suffers from a scandal, then only 80% of my portfolio is safe. By most measures, I’m concentrated.

If I twice many stocks—10 companies—then 90% of my portfolio would be safe. My safety level rises 12%. But if I then double the number of stocks I own—to 20—my safety level only rises 6%. Double it again, to 40, and my safety only rises 2 1/2 percent. There are diminishing gains to diversification, as far as risk-control is concerned.

This only makes sense. In most areas of life—exercise, diet, recreation—a moderate amount is good; overdoing it is bad. Aristotle called it “the golden mean.”

Douglas R. Tengdin, CFA

Chief Investment Officer

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