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The Dangers of Having an Overly-Diversified Portfolio with Too Many Shares

The benefits of having a diversified portfolio have long been espoused by most in the financial industry: Diversification allows you to be exposed to many industries and helps lessen the risks of your portfolio getting dinged badly from a downturn in any one particular sector.

However, too much of a good thing can be bad for you and there are indeed disadvantages of having an overly-diversified portfolio.

The costs involved

Firstly, most brokerage firms will typically charge a minimum brokerage fee for each purchase made. If the purchase is above a certain limit, they will then charge a percentage of the purchase amount. On average, brokers normally charge about 0.2% for every purchase that crosses the threshold.

If the size of your portfolio is not large enough, having an overly-diversified portfolio of say, shares in 100 different companies, will result in transaction fees eating up a huge amount of your capital due to the commissions involved as well as the sheer number of trades needed to be made.

Difficulty rebalancing

The difficulty in rebalancing a portfolio with too many counters is also an issue. As the value of each share in your portfolio changes over time, you might need to rebalance it once in a while. But though it might be quite easy to rebalance a portfolio with just 10 companies, it’s not as simple to rebalance a portfolio with 100 companies. And lest we forget, there’s also tremendous costs involved as I’ve mentioned previously.

Lack of time

Like everything we do, we want to focus so that we can produce better results. As an individual investor with other duties in your professional and social life, you might not be able to attain any deep understanding for any of your shares if you wind up holding a portfolio with hundreds of companies. You might have cursory knowledge of each company you own, but that will only make you, as the figure of speech goes, ‘a jack of all trades but master of none.’ I do think investing in such a manner – being too diversified – can be a waste of time and it’s likely your performance will suffer as well.

An individual’s investing activities can be much more efficient and effective if we own only a handful of companies in which we have a deep understanding of their businesses, future prospects, and risks. In such a situation, we can then be alert to any issues that may arise with any one of our holdings and also have enough knowledge to be able to make an informed decision on how to deal with the issue.

Foolish Summary

Diversification does have its benefits. But investors must be aware of the pitfalls, such as the huge costs that could be potentially be involved when buying shares in a huge number of individual companies. For those casting a watchful eye on costs, exchange traded funds (ETF) that track a market index could be a solution.

In Singapore’s context, there are two ETFs, the SPDR Straits Times Index ETF (SGX: ES3) and Nikko AM Singapore STI ETF (SGX: G3B), that track the Straits Times Index (SGX: ^STI).

The Straits Times Index is one of the most widely quoted market barometers we have of our local stock market and it’s made up of 30 different companies. Investors in the ETFs would thus get instant exposure to those 30 companies by making only one trade. But buyers beware – while ETFs can be an elegant solution to the cost-issue with diversification, they too, come with their own set of risks.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.