Portfolio Diversification: Too Much of a Good Thing?
Steve Lewis, CPA
Diversification is a critical concept when assembling a risk-conscious investment portfolio. If you own a variety of investments, including several different types of investments, poor performance from one or more of them is less likely to depress the value of the entire portfolio.
So, it is tempting to conclude that, if diversification is a good thing, a lot of diversification is even better. Not so. Owning too many investments or spreading assets across too many asset classes can work against you.
Diversification is designed to reduce the impact of losses that you might experience when certain asset classes, particular market sectors or even the general market is struggling. While some investments or asset classes lag, others may perform well, or, at least, not as badly. Thus, diversification helps reduce the overall volatility of your portfolio.
Although diversification helps manage risk, it will never keep your portfolio fully protected from losses. For example, in times of financial crisis, many investments or asset classes move in tandem and punish even well-diversified portfolios.
Although the risks of underdiversification are relatively clear, the negative implications of too much diversification may initially be harder to see. However, there are several reasons why owning too many investments or investment types can work against your portfolio:
The more investments you have in your portfolio, the harder it can be to keep track of all of them. It is more challenging to monitor each investment’s performance and understand when something fundamental has changed with individual stocks or mutual funds. Consequently, you may not know when it is prudent to rebalance your portfolio or change your investment strategy to remain on target toward long-term financial goals.
- Portfolio Overlap
Another potential risk of overdiversification is holding overlapping securities. The more individual investments you own, the greater the likelihood that you may not be as diversified as you think. For example, if you have two small-company growth mutual funds in your portfolio, the odds are good that they hold some of the same stocks. Not only does this mean that you are duplicating investment costs, but also that you are getting greater exposure to certain stocks than you intended. Bigger positions can seem like an advantage if those stocks are doing well; however, not if they stumble and make your portfolio more volatile.
Research has shown that, at a certain level of diversification, investment portfolios tend to produce consistently mediocre returns. This happens because, when you have a large number of holdings, the returns of high-flyers become diluted by the average-to-poor returns of the portfolio’s remaining investments.
To review, a portfolio of two stocks is less risky than a single-stock portfolio because performance problems with one security can be offset by the other security’s higher returns. However, the opposite is also true. If a single stock performs well, a less-robust second stock can limit overall portfolio returns. The challenge for investors is to limit risk while encouraging returns. So, while diversification is an essential investment tool, you need to use it wisely.
Optimal Number and Type
Recognizing when you might have reached the point of overdiversification is not always easy. That is where financial professionals come in. Your advisor can help you determine an appropriate number and type of investments so that diversification strategies support — not undermine — your financial objectives. However, as always, note that no investment strategy, including diversification, can guarantee gains or prevent losses.
Short-Term Needs vs. Long-Term Retirement Savings
Tom Kosinski, CPA, MST
IRAs and employer-provided retirement plans are designed to promote long term retirement savings. The benefits include attractive tax-deferral savings and accumulation of earnings. The costs do not begin until you pay taxes on the distributions, or face penalties on early withdrawals. However, at some point, you may be tempted to use a retirement plan for immediate financial needs. Before you decide what to do, you need to consider the potentially high costs of your choice.
The Cost of Withdrawals
Withdrawal rules are different for IRAs and qualified plans, such as 401(k) plans. Generally, you can withdraw funds from an IRA for any reason, as long as you are prepared to pay the taxes and penalties. Some withdrawals are penalty-free, including those used for health insurance (if you are unemployed), the purchase of a first home and the extraordinary expenses needed to pay for college tuition, disability-related costs and deductible medical expenses.
Withdrawals from qualified plans are generally not permitted before you retire, die or become disabled. However, some plans permit in-service withdrawals for employees who reach 59½ or normal retirement age, or hardship withdrawals for certain expenses. These withdrawals usually are taxable income and subject to a 10% penalty if you withdraw funds under the age of 59½.
You should also consider the loss of tax-deferred growth on any withdrawn funds. For example, if you have $100,000 in your company’s 401(k) plan, contribute $15,000 per year to the plan, and have 15 years until retirement, you have a big incentive to leave the funds in your account. It will grow to almost $670,000 (assuming a 7% rate of return) at retirement. After retirement, you may benefit to withdraw funds in a lower income tax bracket than you currently are taxed. However, if you withdraw $30,000 from your plan account to pay your child’s college expenses, you will owe income taxes and penalties on that amount now and reduce your retirement savings by more than $80,000 over the same 15-year period.
The Option of Taking Loans
Some qualified plans permit loans of up to half of the vested account balance (up to $50,000). With such plans, borrowing may appear to be a “free” option, since there are no income taxes or penalties and you pay the loan interest to yourself.
Nevertheless, any amount you borrow you may reduce your account’s future potential growth. The loan interest you pay generally will not be deductible. Also, you may lose the ability to make contributions or receive matching contributions during the term of the loan. Finally, if you lose or quit your job, you will have to repay the loan immediately or owe income taxes and penalties.
Other Options May Be Less Costly
In most cases, taking an early withdrawal or loan from your retirement account will have long-term consequences on your retirement savings. Since it is difficult to fully assess the long-term costs of a short-term need, most retirement plan assets should be regarded only as a last resort. So, you may want to consider other options, such as borrowing from a bank or family member, and avoid the quick decision to take funds out of your long term retirement savings.