Can You Over Diversify?

Casey Weldon - Cat
Painting by Casey Weldon
In a word - Yes.

At least I think so.

But I think that there are multiple ways to over diversify. The first one that you probably are already thinking of is owning over 100 different individual stocks. There's probably no way you can keep up that well with all of those companies on a regular basis unless you happen to work in finance or have a LOT of spare time on your hands.

But because of over diversification you may be killing your returns without even knowing it. Investors think that they are playing it safe by spreading their money around everywhere when in fact they may be whittling away at their returns before they even start.

Transaction Fees - The Silent Killer

Whenever you buy a stock you have to pay a transaction fee, the same goes for when you sell a stock. These fees range from usually about $5-$10 with the average coming in somewhere around $7 so essentially you will have to pay $14 every time you pick up a new investment. This amount can be significant depending on if you are over diversifying.

Many investors believe that they are doing the safe thing by spreading their money out over a lot of different companies. And yes there is merit to that, but some people spread out too much too quickly. Here's an example, let's say I have $1,000 to invest each month because I'm doing a good job saving. If I put all of that money into a single stock I will have to pay $14 overall to buy it and eventually sell it later. That comes out to an automatic loss of 1.62% of my investment before I even started. Now I realize that doesn't sound like a lot but it will add up over time.

Let's say you want to save $700k for retirement and you contribute $300k and let compound interest do the rest over a few decades. If you invested your money $1,000 at a time, you would end up paying about $4,770 in transaction fees which is not a small amount. You could buy a lot of stuff for that much money. And this is all just paid to the brokerage firm that you invest with. This also assumes that over that time you only bought and sold things once. But to be fair we are probably investing in some of the same companies again and again so you might have less transactions on the selling side. But since we may rebalance later or find better investments and move things around, let's just assume 2 transactions each $1,000.

This is where diversification is killing investors. Some people break up this small amount into even smaller chunks. They will put $500 here and another $500 there. Instead they are doubling their transaction fees up to 2.88% and overall transaction fees on $300k to $8,400. Here's a quick table of transaction fees and how much they are stealing from you in transaction fees.

Transaction Fee Comparisons


I know that you want to use the proper investing strategy, but buying stock $500 at a time is not the way to do it. If the stock market returns on average 7-8% per year then losing half of that in transaction fees means you are making no progress for half of a year.

If your nest egg will eventually be over $500k (which is a pretty low estimate since some places like Fidelity suggest over 2 million now) then diversifying into $500 chunks makes no sense. You aren't going to have a few hundred different stocks, you will probably end up somewhere around 50 or less. Since this is the long term goal then why are investors so interested in reaching the goal of 50 stocks as fast as they can? That's just going to make you pay more transaction fees.

The Dividend Investors

Dividend investors have this approach where they buy but never plan to sell which is great but you can't guarantee that will always happen, sometimes large companies fail or sometimes you just need to rebalance. Even if this was the case, breaking your investment up into smaller chunks means you are losing more on transaction fees still. I would say average dividend portfolios return somewhere around 4% per year, so if you spend almost 2% on transaction fees you lost half a years worth of dividends.

Diversification is great, but over diversification can be a killer. Personally for me, unless I see a really great opportunity I usually wait until I have about $2,000 or more to invest at a time just to keep the transaction fees to a minimum.

This doesn't really apply to Index or ETF investors. I personally have a chunk of my own money in Index funds to help keep myself diversified. There are even funds within certain brokerages that do not have transaction fees which are a fine option. But even within these funds investors should take note of the management fees. It's becoming more well known that high management fees will kill your returns over the long run, and a high management fee is usually something over 1%, it could even be less than that. All of the fees on my Index funds average around 0.12% so I paid attention to that too.

So don't forget your fees!

How do you invest new money? Do you over diversify?

11 comments:

  1. Zee,

    I don't think this is so much a diversification issue, but rather a capital allocation issue. I agree that spreading around limited capital too much will only hamper your success, however. If you only have $1,200 per month to invest and you're subject to $7 fees, then you're best off just investing that $1,200 in one company. And this is typically what I've done.

    Now, over diversification might be investing that $1,200 in different companies for 100 months straight, building up a portfolio of 100 stocks with $1,200 each. But careful capital allocation must be considered, because fees can definitely eat you alive. I personally aim to make sure each transaction is around $1,400 or more, but I do sometimes fall short of this when capital is a bit tight.

    And you make a great point. If you're eventually going to have a $500k portfolio, then trying to spread around capital too much makes absolutely no sense. If you aim to have 50 stocks in your portfolio, then you're going to have ~$10k in each position anyhow...so why fuss over $1,000 or so?

    Thanks for the great thoughts!

    Best wishes.

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    1. Dividend Mantra,

      You're right that it's not necessarily diversification that's the issue, it's allocation that drags people down. I completely agree with you that if all you have to invest at a time is $1,200 then you should invest it all then instead of waiting for over a month when you can get over some arbitrary threshold that makes the fees okay.....

      Sometimes sitting on the sidelines just keeps you out of the game.

      The only reason I mentioned this and wrote about it is because sometimes I see other bloggers write about how their goal for the month is to invest that $1,200 into 3 different companies so that triples your transaction fees. Their reasoning behind three separate investments is diversification and that's the part where I think they are better slowing down their diversification. If you only have $400 a month to invest with, then that's what you have to work with. But if you have $1,200 and you want to triple your transaction fees then I think you're just making yourself stumble out of the gates.

      There was one time where I had very little cash available to purchase a new investment but the opportunity was telling me that "I needed to do this, NOW" and that was when Facebook stock dropped to $19 per share. I only had $300 available at the time which normally I would said it wouldn't be worth the transaction fees but it was one of those deals you just had to do.

      There are exceptions to every rule, and that is one of my exceptions: when there's a deal that's just too good to pass up on. But I don't try to force myself to allocate myself thin just for the sake of diversification.

      Thanks for your comments!

      -Zee

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    2. Hello,

      Interesting article. However, I don't think you are comparing apples to oranges.

      Let's think of it this way. You are going to put $1000/month to work for 100 months ( total of $100K). You pay your broker $7/trade. ( that's $700). Sure, you might end up selling at some point - nothing is guaranteed in life.

      However, if you were to buy even an index fund, where you pay no commission but you pay 0.10% per year, every year, you will end up paying $100/year EVERY year in fees ( once month 100 comes). In reality you will be paying much more, since your money will compound over time.

      I personally buy companies I think are good values. If I own 50 companies already, which are overvalued, but good holds, it would make sense to buy 5 - 10 more companies that are good values today. In other words, i like CL and will hold it "forever". But it is expensive as hell. If would much rather buy something else, and have more than 50 companies than stick myself in an artificially created container.

      Under-diversifying could be dangerous as well. Plus, once you have really done your homework, how much time do you really think it takes to monitor a company for material changes? If you check "news" or "opinions" on companies of JNJ every day, then chances are that you are merely wasting time, rather than being productive in researching your investments.

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    3. Dividend Growth Investor,

      I think that you are completely right that paying a small management fee on a large amount of money will cost more than the initial transaction fees over the long run. I think that if you are the type of investor that invests in companies that aren't the fancy names that impress people like 3D printing companies and social media companies that may or may not be around in the next 10 years then yes, a small transaction fee on a strong dividend paying stock is a great way to go. But I was trying to bring up the point of not letting diversification for the sake of diversification slow you down.

      I'm not sure of how you invest, but I imagine that if you had $1500 to invest each month and you expected that amount to not change anytime in the near future (assuming you don't lose whatever job you do to make that money) you probably wouldn't split that $1500 into 3 smaller investments of $500 that month, just for the sake of purchasing 3 companies instead of 1 larger position in 1 company. I think that if you spread your money too thin too quickly then you're just paying a lot more transaction fees than is really necessary.

      If you invest $1000 for 100 months then yes it's $700 in fees that you're paying, but if you allocate your money into twice as many companies just because you want to diversify more, then you'd be paying two transaction fees every month and then your fees over 100 months would be $1400.

      Under diversification is also not a good way to approach investing. I think the all your eggs in one basket approach only works if you have a small basket (nest egg). The more money you have invested the more you need to start spreading it around.

      Thank you for stopping by and the thoughtful response!

      -Zee

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  2. Diversifying can be of big help. It can reduce the risk to my portfolio. Diversifying investments is the most significant component of reaching long-range financial goals while minimizing risk.

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    1. I have no issues with diversifying, it's just the execution of diversification that raises some flags for me.

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  3. I am all about diversification. I basically own 4 index funds/ETF's with super low expense ratios and some even have no transaction fees because the broker waives them. Fee's can be brutal for sure, and I have no desire to pay those high fees ever again!

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    1. I have a large chunk of money in index funds. I enjoy that those give me huge amounts of diversification with small expense ratios. But I also like to actively pick companies that I have researched and think will do well in the future too.

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  4. Good point on the fees needing to be considered when making a purchase. I would like to make an argument that even if a dividend investor does eventually sell a stock because of a company changing, the amount of years the stock was held on to is important to compare fees. You might have .12% fees on the mutual fund, but this is on the TOTAL value, not just the initial value. So if you make that $1000 investment and hold for 10 years, your two trades will cost ~.10 % over those 10 years, but again, all based on the initial value of the purchase. Your mutual fund will be charging that .12% on the present value each year.

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    1. Kipp,

      You're right, the amount of time that you hold onto something and the more it grows in the meantime the smaller the fees will seem to be. I still think it's better to invest in larger chunks of money at a time if you can. Splitting up your money and paying more of these "nickel and dime" fees is not a very frugal way of investing.

      Though if you ever did come into a large chunk of money such as an inheritance or you got a large bonus or something, then I would think splitting the money up would be a good idea. A while back I got a large check that was owed to me from an old company not paying me for overtime. That was a large enough of an amount where I didn't invest it all in one single investment.

      http://www.work-to-not-work.com/2014/03/why-is-saving-money-such-stigma.html

      And your point about management fees on index/mutual funds is correct too. I will be paying these small fees on them for as long as I hold them, so in the end I'll probably pay more than the $7 transaction fee for a dividend stock. But one of the index funds I have is the Vanguard Total Stock Market Index Fund VTSAX which is a fund that holds everything in the stock market. That is so diversified that I don't mind paying the management fee to help keep balance in my portfolio which is something even 100 dividend stocks couldn't do to the same degree.

      http://www.work-to-not-work.com/2014/05/when-should-i-de-risk-my-portfolio-and-how.html

      It's all a matter of personal choice, I just hope that people don't choose to make their brokerage firm rich off of their trading habits.

      Thanks for stopping by!

      -Zee

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  5. "Always mind your fees" was the first ever investment rule I learned the hard way. Glad someone wrote so precisely about it for the others not to fall for over diversifying investments. Thank you!

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