Diworsification

This is a sequel to my previous post on diversification and is intended to cover (on the contrary) why we shouldn't diversify too much as well.

Diworsification refers to spreading your capital over many investments that are quite closely related or funds with the same investment strategy, which results in worse off returns and risk. So, we have to balance the number of investments in our portfolio in order to maximize returns and reduce risk, especially given our limited amount of time for those who have a full-time job.

Having a portfolio with 100 different assets may sound like a well diversified portfolio, but as mentioned in the previous post, if all of the assets are not well spread out across the different sectors of the economy, different instruments, etc., the portfolio may still face significant risk due to a downturn in that particular industry or investment type.

So, let's say that we have our portfolio well diversified with many investments in the different sectors and instruments. The impact that the failure of one investment will have on our portfolio as a whole will be minimal, but so will the returns on the good investments that we have chosen. By buying up so many investments, we may have inadvertently added (or due to the sheer number of investments and lack of time, not checked) some of the not-so-sound companies that were unlikely to have added to our portfolio had we done a little more research on them.

If we diversify into too many shares, we won't be able to concentrate our limited funds into the companies that we think are the best value and so we get worse returns while having to take on the increased risk from these not-so-ideal companies, which we have taken on solely due to diversification. In order to prevent this, we need to limit our investments to those that we have enough time to cover and continue to monitor over time, as investment conditions and the companies change.

There is no magic number on how many investments you should have to make up a well-diversified portfolio that will maximise your returns, as it would also depends on your risk appetite (if you spread over all investments, you would have reduced the total risk but reduced your returns as well) and the amount of time that you can spend to pick out undervalued companies and continue to track them.

For me, my target is to pick out around 20-30 good investments that are undervalued and invest in them, but this also depends on the amount of time that I'm able to spend on this task and the number of undervalued investments that I'm able to find. By spreading my capital over a reasonably large base of investments, I would be able to reduce the risk specific to a company, industry or investment type, but with it not being too large to be unmanageable, I hope that I'll be able to track them and pick companies that are undervalued.


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