Yes, your investment portfolio can be too diversified

The Financial Post takes a weekly look at tools and strategies that will help make your investment decisions. This week: Diversification.

The concept of diversification is about as close as it gets to gospel for investors. Yet the extent to which stocks, bonds and other assets should be diversified in order to optimize the risk/reward dynamic of an investment portfolio has also been long up for debate.

Picking too few names can lead to a danger of being too concentrated, but loading up on too many can just as easily lead to overkill.

“Over-diversification is superfluous. It can lead to inefficiencies regarding cost, time and focus,” said Greg Newman, associate portfolio manager at The Newman Group, a division of ScotiaMcLeod in Toronto. “On the other hand, under-diversification can lead to a higher risk of underperformance and loss.”

Mr. Newman said he keeps adding names to his holdings as long as the long-term thesis is compelling and it provides the portfolio with something unique, although the key is generally the fewer the better. But to pull the trigger on that kind of opportunity, he needs the time to learn about the business and monitor it over the long haul, which can be hard for retail investors to do.

“The right balance will differ for different money managers and different investors,” he said. “The key is to know what works for you and be true to that process.”

Sounds simple enough, but the debate pitting broad diversification against greater concentration lingers on, with some of the greatest investors of the past 50 years weighing in.

Enthusiastic proponents of diversification include Harry Markowitz, the Nobel Prize-winning economist best known for his modern portfolio theory, and John Bogle, the index-loving founder of Vanguard Invest- ments, who thinks investors should buy hundreds, if not thousands of stocks and bonds around the world through exchange-traded funds.

Keep in mind, though, that a globally diversified portfolio of stocks and bonds may be achieved with just eight to 10 ETFs.

“This i s typically t he number we use i n constructing our portfolios,” said Susanne Alexandor, a managing director at Cougar Global Investments in Toronto.

Proponents of a more concentrated approach to portfolio building, meanwhile, include heavy hitters such as the late Benjamin Graham, who recommended a minimum portfolio size of 10 stocks and a maximum of 30, and his famous protege Warren Buffett, who for decades has questioned the logic of diversifying across dozens of securities when a basket of far fewer will do just fine.

“If you are a know-something investor, able to understand business economics and to find five to 10 sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk,” the Oracle of Omaha has said.

The world of academia has also weighed in countless times on the topic over the years. A 2008 study in the Journal of Financial and Quantitative Analysis, for example, concluded that across all households, the stock picks made by concentrated investors outperform those made by more diversified investors “by slightly less than one percentage point over the year following the purchase, with the difference growing to three percentage points for households with relatively large portfolios (i.e., at least US$25,000).”

Ultimately, there doesn’t seem to be much agreement regarding the degree to which investors should be diversified, but one common theme on both sides of the debate is that investors who have the time and knowledge to properly research companies are better suited to constructing more concentrated portfolios than those who don’t.