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

By | 2014-03-07T10:29:38+00:00 March 7th, 2014|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

Leave A Comment