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When Diversification Can Become Problematic

By Fisher Investments UKMarket OverviewNov 01, 2021 10:42
uk.investing.com/analysis/when-diversification-can-become-problematic-200500556
When Diversification Can Become Problematic
By Fisher Investments UK   |  Nov 01, 2021 10:42
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A diversified investment portfolio is an important part of a successful investment strategy. Simplistically, diversification means blending different types of securities to spread out your portfolio risks. Ideally, no single security, sector, country or asset class should create a potentially devastating vulnerability in your portfolio. When holdings of one company, sector or country fall, the other securities in a diversified portfolio can help provide stability because their price movements are not perfectly correlated.

But, after a certain point, more diversification isn’t always better. It is sometimes possible for investors to introduce inefficiencies, sabotage performance or increase expenses through counterproductive diversification.

The cause

One of the most widely used investment vehicles can lend itself to suboptimal diversification: mutual funds. Mutual funds offer investors an easy way to diversify their portfolio, yet each fund follows its own strategy. Each fund’s manager interprets markets in their own way and implements the investment strategy based on that distinct interpretation.That means owning multiple mutual funds doesn’t automatically deliver the right level of diversification. Some investors might think adding more mutual funds to a portfolio means more diversification. However, investing in multiple funds could potentially open your portfolio and retirement goals up to unintended financial risks.

The risks

  • Overconcentration

Overconcentration can happen when you have more exposure to a particular security, sector or country than is appropriate for your long-term investment strategy. It can happen when investors own multiple mutual funds with overlapping holdings. Imagine you own three mutual funds, and each one is invested in the US tech sector—perhaps even the same companies. This means your overall portfolio may be overconcentrated in that sector and the handful of companies each fund holds. Intending to build a well-diversified portfolio, you may end up doing exactly the opposite.

  • Unfocused strategy

An unfocused strategy can happen when your various mutual fund managers make conflicting decisions. Suppose you’re invested in two mutual funds run by different managers. In one fund, the manager decides to buy equity holdings of Country A because she feels those assets may perform well. Meanwhile, the other fund’s manager decides to sell Country A’s equity holdings because he believes those assets will perform poorly. You end up paying transaction costs for disjointed decisions that ultimately may have no net effect on your portfolio.

  • Potentially higher transaction costs

Excessive diversification with mutual funds can mean you’ll pay more for transactions across your holdings. For example, if you own a dozen mutual funds and each mutual fund holds 300 stocks, you may hold as many as 3,600 companies’ shares without realising it. As each fund’s manager buys and sells those shares, you and the funds’ other investors end up bearing the implicit and explicit transaction costs.

  • Paying multiple fees and expenses

Most investors know about the various management fees that mutual funds carry. But, not all investors know about the additional costs—administrative and marketing fees, transaction costs and other operating expenses —that come with many mutual funds. If you pay attention to the average “expense ratio,” or average costs a fund must cover to operate, you can see the extent to which these additional fees could erode your gains—especially across multiple funds.

The response

Fisher Investments UK believes the benefits of mutual fund ownership don’t accrue equally to all investors. For example, investors with smaller portfolios may need to pool their funds with other investors to achieve proper diversification; thus, mutual funds can make sense.

On the other hand, high net worth investors likely have more flexibility to customise an efficient portfolio by investing directly in equities or fixed interest securities.

Diversifying your portfolio through direct equity purchases can bring several benefits:

  • Decrease the inefficiencies associated with fund turnover, management fees, operational expenses and potential taxes for fund liquidations by other investors.
  • Reduce the risks of overconcentration in a given market category or sector and exposure to conflicting investment strategies among different fund managers.
  • Most importantly, direct equity investments can give high net worth investors a more transparent, customisable, and cost-effective way to diversify their portfolio.

Ultimately, Fisher Investments UK believes retirement savers and other long-term investors would benefit by scrutinizing how they use mutual funds as part of their investment strategy. For certain investors, direct equity investment may bring advantages that help them reach their investment goals more efficiently.

Interested in planning for your retirement? Get our ongoing insights, starting with a copy of 7 Secrets of High Net Worth Investors.

Investing in equity markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments UK and should not be regarded as personalised investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments UK will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

Follow the latest market news and updates from Fisher Investments UK:

Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square (NYSE:SQ), Canary Wharf, London, E14 5AX, United Kingdom.

Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

When Diversification Can Become Problematic
 

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When Diversification Can Become Problematic

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