There’s no such thing as overdiversification

The investor’s aim should be to reduce risk and beat the market

If financial advisers and stockbrokers weren’t paid for advice or execution, I reckon that being paid by the cliche would be a pretty good substitute. Not only does the financial services industry specialise in trying to make things sound more complex than they really are but it does so in a fog of jargon and double-speak.

Perhaps it’s because they’ve forgotten that they’re talking to real people. Or, less charitably, because the more difficult they make it sound, the less likely you are to do it yourself (and take a little gravy off the fees gravy train).

Of course, phrases become cliches largely because they’re true more often than not. Take a universal favourite among financial types: diversification is the only free lunch in investing.

Which, on the surface, sounds good, right? After all, diversification doesn’t cost you anything and it protects you from being too badly impacted by a disaster that might strike one company, sector or industry. After all, if you only own shares in one bank and one home builder, you’d better hope Australians don’t fall out of love with property anytime soon.

So diversification is good. After all, who doesn’t want a free lunch? Well, yes, but the problem is that many people take diversification too far, ending up with what I like to call a Noah’s Ark portfolio: two of everything. Which pretty much defeats the purpose of buying shares in the first place.

Don’t get me wrong: I’m a huge fan of broad-based index funds (exchange traded funds, or ETFs) as financial products. They are usually ultra-low-fee options that can give you access to the total market return with a single click. The stockmarket tends to average around 10% a year (with large yearly variability), so it’s a quick, cheap and painless way to access the future returns of the market as a whole.

But if you’re buying individual companies, it should be because you want to beat the market return. (And if that’s not your aim, then you should consider just buying the market instead: trying to pick stocks and doing worse than average – over the long term – is a waste of time and money).

Which is how we end up going full circle. If you’re trying to beat the market but you have a “two of everything portfolio”, you’re up against it. Such an approach doesn’t allow for an assessment of particular industries or companies. For example, if banks underperform the market over the next few years (which I think is likely), why would you want to own them? I feel the same about airlines. Are infrastructure companies likely to beat the market in a rising interest rate environment? Do you really want to buy overpriced fintech companies just because they’re there?

On the other hand, given Australia makes up less than 3% of the world’s stockmarkets, how diversified are you if you have two each from the Australian banking, mining, retailing, technology and utilities sectors but have no exposure to the consumer goods, social media, entertainment and pharmaceutical giants domiciled on overseas exchanges?

Do you really want to buy overpriced fintechs just because they’re there?