Deworsification: Too Many Eggs In Too Many Baskets
Is it possible to be too diversified? Is there an ideal number of individual investments in a portfolio?
Written by Victoria Kent, Senior Investment Specialist
This information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs.
All investors are familiar with the concept of diversification – the purpose is to reduce the impact of individual investment losses by spreading investments across different assets or asset classes. It's the answer to "not putting all your eggs in one basket".
The term "deworsification" means something entirely different, and was coined by renowned investor Peter Lynch in his 1989 book "One Up On Wall Street".
He used it to describe a situation where a company or investor ventures into businesses or industries they do not fully understand or have a competitive advantage in.
Although Lynch referred to a company-specific problem, deworsification has evolved into an investment concept that describes the fallacy of adding too many asset classes with similar correlations to a portfolio, negatively impacting risk and return.
While the benefits of proper diversification cannot be denied, there is a point where adding another investment to your portfolio can exceed its marginal benefit. This is the point of deworsification, i.e., being over-diversified.
It begs the question: is there an ideal number of individual investments in a portfolio?
There is no one-size-fits-all answer to this question, as each investor's circumstances and preferences differ. The ideal number of individual investments in a portfolio can vary depending on several factors, including the investor's risk tolerance, investment goals, time horizon, and the specific assets being considered.
For some, this could be 20 or 30 individual securities. For others, it could mean over 10 ETFs and managed funds as they seek diversification through differing mandates, countries, asset classes and managers.
The key is ensuring the assets are uncorrelated to help reduce the overall risk (correlation measures the strength of the relationship between two assets).
Correlation is key
People tend to underestimate the amount of correlation between assets. They may think they’re diversified because they own several asset classes and securities. In reality, their assets may be highly correlated – external factors such as rising interest rates may have a similar impact across a portfolio, for better or for worse.
It's important to note correlation is not fixed; it changes over time. Often when markets are in decline, correlation is at its highest.
An example of this is the general relationship between equities and bonds.
While they are two distinct asset classes, their respective performance can be correlated. For example, a rising interest rate environment can cause equities to pull back as investors become concerned over higher interest rates impacting corporate earnings and economic growth.
In a similar vein, corporate bond yields can potentially increase for the same reasons. Bond yields rising in line with interest rates will reduce bond prices, and thus be correlated with the share price decline of equity securities.
So, where does one find assets to diversify away from equity securities?
It is rare to find asset classes with zero correlation. After all, economic news and changes to government policy can impact a wide range of asset classes. However, attempting to find assets with as close to no correlation should be the aim in a diversified portfolio.
Traditionally, diversification has been found through investing in asset classes such as precious metals (gold), real estate (particularly real physical property) and some credit products.
Other assets that have become more popular in recent times include digital assets such as NFTs and cryptocurrencies, as well as physical collectibles such as art and antiques. But just because an asset is investible, doesn’t mean that it is appropriate for you or your circumstances.
Summary
Diversification is a key portfolio management technique as a way of reducing investment risk. However over-diversification, or ‘deworsification’, can create confusion and lead to weaker-than-expected risk-adjusted returns. The ideal number of securities held in a portfolio can vary based on the needs of the individual investor. It is for this reason we recommend you obtain professional advice when constructing your investment portfolio.