A New Way for Investors to Think About Diversification

By Frank Grinnell

Diversification is a cornerstone of sound investing, but it can be overdone. The term refers to an investment strategy where investors allocate capital to a variety of assets to minimize the risk of missing out on big gains or limiting losses.However, investors could be leaving money on the table by watering down their portfolio with too many investments.

Over-diversification, or diworsification as Peter Lynch coined it in his 1989 book, One Up on Wall Street, is when the number of investments in the portfolio exceeds the point where marginal loss of expected return is greater than the marginal benefit of reduced risk.

Financial advisors should avoid over-diversifying client portfolios, instead opting for a smaller number of high-conviction investments to maximize returns as well as client trust and satisfaction.

The Risks of Over-Diversification

The most obvious unwanted effects of over-diversification are redundancy and duplicated efforts. Clients can end up with the same financial products in different packaging. For instance, investments in index funds through two different companies. This could lead to overweighting in some instances and overall is not making good use of client capital.

It can also lead to excessive complexity. Diversifying to the point that the reduced risk is negligible confuses investors and dilutes returns while also increasing costs. Transaction fees can add up and also deplete returns.

Further, because diversification is a tool to reduce risk, not to improve returns, an over-diversified portfolio can lead to below-average returns for clients.

How to Avoid Over-Diversifying Client Portfolios

Though it is almost impossible to diversify away market risk, advisors can simplify client portfolios and reap the benefits of diversification without over-diversifying.

One way to accomplish this is to sell similar holdings. For instance, if a client owns a S&P 500 index fund and a technology ETF with holdings listed on the NASDAQ Composite Index, their portfolio may be over-diversified. The S&P already has exposure to information technology at nearly a third of its holdings at the time of writing, including its five-largest stock holdings.

Often, the best way to manage diversification is to hold a smaller number of high-conviction investments. Clients should consider trimming investments in sectors that are only included in the portfolio for the sake of diversification. Assets should instead be placed in a smaller quantity of stocks that are likely to perform. Holdings with strong balance sheets and cash flow will contribute to above-average performance in a market decline, and these companies will be among the first to recover when the market bounces back. A simpler approach to investing can lead to higher returns over time while making it easier to manage the portfolio.

Through the Accelerator Model, Grinnell Capital offers a new, dynamic method of diversification and defensiveness that actively invests capital across various sectors and market capitalizations, with a focus on macroeconomic influences to target companies poised for growth. We have found the most powerful returns can be made by concentrating a portfolio around our highest conviction ideas.

About Grinnell Capital

Grinnell Capital is an investment management firm founded by Frank Grinnell and Dana Grinnell, a team with over 40 years of combined experience in investment management, business ownership, and executive leadership. 

 

We aim to simplify investing through two distinct products: the Accelerator Model and the Ignition Model.

 

The Accelerator Model is a concentrated portfolio of inefficiently priced and disruptive companies poised for growth that are selected using a disciplined, fundamentally-driven investment process underscored by stringent risk controls.

The Ignition Model is a portfolio of ETFs designed to provide sector-specific exposure and capitalize on market trends.

By providing a simplified approach to investing, we endeavor to help our investors live confidently. Contact us to learn more about Grinnell Capital.

Disclosures:
Grinnell Capital is an SEC-registered investment adviser. Registration does not imply a certain level of skill or training. For additional information about Grinnell Capital, including its services and fees, please review the firm’s disclosure statement as set forth in Form ADV and is available at no charge at https://adviserinfo.sec.gov/firm/summary/311742.

This information is provided for informational purposes only. The information contained herein should not be construed as the provision of personalized advice and is subject to change without notice. This material should not be considered as a solicitation to buy or sell any asset or engage in a particular investment strategy. Investing in securities involves the risk of loss, including loss of principal invested, and may not be suitable for all investors. Past performance is no guarantee of future results.

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