The Danger of Over Diversifying Retirement Savings

Written by , April 17, 2012

The Danger of Over Diversifying Retirement SavingsFor years we’ve heard the traditional financial advice that diversifying our investment portfolios is a good idea. The thinking was that if we have a number of different investment types and risk exposures, then a downturn in any particular market segment or asset type would only affect a portion of our portfolio.

But over the past few years we’ve seen that the relative degree of “safety” that can be gained from broad diversification may not be as much as we thought. In fact, according to some financial commentators, over diversification might actually be a negative in that it prevents us from focusing on the strongest performing market segments. These issues also apply to our retirement savings.

Here’s some retirement advice to help you recognize when you might be at risk of over diversification.

  • Over Diversification Can Distract You. Your retirement savings is likely different from your non-retirement investment accounts in a number of ways. Depending on how close you are to retirement (or if you’ve already retired), you’ll want to have a certain type of asset allocation to meet your retirement needs. In broad terms, the allocation will be amongst stocks (or other growth-oriented investments) and bonds (or other relatively stable value income-generating investments). The more money you have in your retirement account, and the closer you are to retirement, the more this allocation is likely to be weighted towards bonds. Over diversifying could potentially take you away from your optimal account balance. Focus on that allocation before you worry about diversification.
  • Over Diversification Can Keep You From the Big Winners. It’s a simple matter of math – the more investment holdings you have, the less you can have invested in a particular stock or fund. This means you might miss out on the big market “winners.” In 2011, for example, the Dow Jones Industrial Average gained about 5.5%. But 40% of the stocks that comprise the Dow actually declined over the year. By diversifying into the Dow Index, the gains of the stocks that comprise the top one-third of the Dow (which gained anywhere from 12% to 30% on the year) were significantly diluted. Over diversification occurs when the protection you gained from adding another investment to the mix is outweighed by the risk that you’re missing out by taking those funds away from a potential winning investment.
  • Over Diversification Can Cost Too Much. If you over diversify in your retirement account (or any investment account, for that matter) then you are at risk of overpaying – in terms of fees as well as the time it takes you to manage your many different holdings. You should focus on the goals of your retirement savings account (which might include current income, preservation of capital as well as growth – in varying amounts depending on your needs), and let that drive your diversification strategy.
  • As with any investment strategy, there is no “one size fits all” answer. Diversification can protect your retirement savings to some extent, but over diversification has its risks as well.

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