The Limits of Diversification
Diversification has its limits when it comes to mitigating risks. It is very useful in mitigating the unsystematic or company-specific risk that comes from investing in an undiversified asset. However, it cannot eliminate the inherent risk that comes from investing in the market.
With this in mind, diversification can only lower your risk to a certain extent, regardless of the number of investments you own. However, what does not decrease, as your holdings increase is complexity.
Often, adding complexity (your portfolio) on top of complexity (the markets) can increase risks rather than reduce them.
The Potential Downsides to Complexity
First, it makes it more difficult to manage a portfolio. Every additional holding means additional research, due diligence, monitoring, and time spent actually trading the investments.
Second, it can increase the costs of your portfolio. More holdings mean more trades and trading fees. In addition, you could be paying additional management fees without the added diversification benefits. This is due to your funds holding the same underlying assets. When this is the case, you likely could achieve similar returns by holding a lower-cost index.
Lastly, a portfolio with many different investments also raises the risk of tinkering. This is because we have a bias towards taking action and doing something feels better than nothing. Having many individual components in your portfolio may tempt you to unnecessarily sell/replace an investment. This is especially true when an investment is performing poorly.
Finding the Appropriate Balance in Retirement
As you approach retirement, you want to develop an investment strategy that allows you to achieve broad diversification while minimizing complexity. Thankfully with the rise of low-cost broad index funds, a globally diversified investment portfolio is within reach for the vast majority of savers.
The more individualized portion of your investment strategy is deciding the mix of stock, bonds, and cash alternatives you will hold in your portfolio. This asset mix should be based on your need to fund both your current and future expenses.
This process is relatively straightforward in theory, but in reality, can be challenging when factoring in the unpredictable nature of the markets. This is why it is important to have a plan in place ahead of time so that you can be proactive rather than reactive in your decision-making.
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