In the late 1990s and early 2000s, film rental chain Blockbuster enjoyed significant global success.
At the time, if you were looking to invest in the entertainment sector, Blockbuster might have seemed like a safe bet. After all, the company was worth billions and had become an important cultural icon that seemed likely to continue growing in the future.
Yet, as you may know, Blockbuster filed for bankruptcy in 2010 and has since ceased to exist.
The rapid advancement in technology and onset of streaming services such as Netflix revolutionised the way we watch films and Blockbuster failed to keep up. So, a company that once dominated an entire sector failed in the space of a decade.
This is one of many examples that demonstrates the importance of diversification in investing.
If you’d put all your wealth into Blockbuster, you would have made significant losses when the business failed. Yet, if you’d also invested in emerging companies like Netflix, and bought shares in different sectors or countries, gains from elsewhere might have balanced your losses.
As a result, the overall size of your portfolio might still have grown, despite certain investments losing some or all their value.
By diversifying your investments in this way, you could manage the level of risk you adopt and potentially mitigate losses during a period of market volatility.
That said, you can have too much of a good thing.
In some cases, “overdiversification” can create unique challenges that make it harder to grow your wealth.
Read on to learn what overdiversification is and how it could affect your investment portfolio.
Diversifying your investments could reduce the level of risk you adopt
If you put all your wealth into a single stock, the value of your portfolio is dependent on the success or failure of one company.
Should that business grow significantly, you could see notable returns because you’ve put all your wealth into it. On the other hand, if the company faces difficulties, you could experience significant losses.
As such, this would be a very high-risk, high-reward option.
Now imagine you add a second stock to your portfolio. This may reduce risk because if the first stock falls in value, the second might grow. Those returns could offset your losses from the first investment.
This is the basic principle of diversification.
Investing more widely may also diminish your returns
While diversification could be an effective way to manage risk, it’s important to note that your overall returns may not be as high as they would be if you invested in a single stock.
Using the example above, this is because only a portion of your total investment is in the successful company. Meanwhile the rest of your wealth is in a stock that is losing value.
As such, diversifying your investments could mean the risk is lower but the return may also be diminished.
When balancing a portfolio, you may be willing to accept some reduction in your returns if you can also reduce the chances of significant losses.
Getting that balance right means you may be more likely to achieve sustainable, positive growth over time.
Overdiversification occurs when adding investments affects returns without meaningfully mitigating risk
Diversifying your investments could reduce risk but if you invest too widely, you may upset the balance.
If you have a well-diversified portfolio your level of risk may already be suitable for you. In some cases, if you continue unnecessarily adding more investments, you could reach a point where you diminish your returns but don’t see a meaningful reduction in risk.
This is overdiversification.
While past performance doesn’t guarantee future returns and you won’t necessarily reduce returns with every investment you make, it’s important to be mindful about spreading your wealth too thin.
Investing too widely could make your portfolio more difficult to manage
As well as potentially reducing your returns, overdiversification could make it more difficult to manage your portfolio.
It’s important to understand what you’re investing in and keep track of how various stocks and shares, or funds, are performing. That way, you can track your progress towards your goals and adjust your portfolio, if necessary.
However, if you overdiversify and invest too widely, it could be far more difficult to keep track of everything. This could mean that underperforming investments go unnoticed and erode the value of your portfolio.
Professional advice can help you avoid overdiversification
Finding the right balance between diversifying and overdiversifying can be challenging.
There is no “correct” number of different investments you should hold because it all depends on the specific make-up of your portfolio and your goals. That’s why it’s crucial to create a tailored investment portfolio that is unique to your financial plan.
Professional advice is so valuable here as we can help you select investments based on your attitude to risk and balance your portfolio, without spreading your wealth too widely. Additionally, we can keep track of your portfolio for you and conduct regular reviews to ensure you achieve the growth you need to meet your goals.
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We can support you in creating an investment portfolio that is suitable to your risk tolerance and financial goals.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.