Diversifying too much can harm your investments; understand – 11/21/2023 – From Grain to Grain

Everyone has heard about the importance of diversification. It plays a fundamental role in a portfolio in improving the balance of return and risk. However, just like everything in life, when diversification is exaggerated, it can end up hindering your results.

Knowing how to dose a medicine is a science, but in some cases, an art. Diversification can be seen as a remedy to improve the risk of a portfolio. So, how to dose it?

Unfortunately, there is no one-size-fits-all rule for all products and assets. The analysis must be carried out according to the characteristics of the products.

I’ll give an example of a mistake I’ve made in the past, but I learned from my own mistake.

Yes, you are lucky to learn from my mistakes. I have worked in the financial market for over 26 years. You can’t help but make a lot of mistakes when you’ve been on the market for so long.

As I tell my students: The only thing that is certain in the financial market is that at any moment you can be wrong about something in your investments. The person who discovers the error the fastest and corrects it wins the most.

So I hope you too don’t make mistakes long enough before realizing you were wrong. And today, I’m going to give you an example of something you might be getting wrong.

Stock research houses, banks and brokers usually put together suggested investment portfolios. When the investor is moderate or aggressive, there is a portion dedicated to stocks. Sometimes this investment in shares is suggested through equity funds.

So far, so good. I am in favor of both approaches, both having a direct stock portfolio and investing through stock funds. There are exceptional equity management teams with excellent results over time.

I emphasize, the issue is not investment through funds, but the number of funds that it is suggested to have in your portfolio.

Today I saw a suggestion from a renowned research house that consisted of 8 equity funds.

Someone may ask: wouldn’t having more equity funds be better to promote diversification?

Without a doubt, having more is better than having just one in terms of improving diversification. However, 8 is too much for the Brazilian case.

The error is not theoretical. The problem is the market.

We usually study finance in foreign literature. In the American market, there are more than 4 thousand companies with shares listed on the stock exchange.

Therefore, it is possible to have 10 funds in a portfolio and even without any overlapping of companies, still not reach 30% of the S&P500 index, which is the main American index.

Out there, due to the diversity of companies, a fund may have several shares that are not in the index, as they have trading liquidity.

The Brazilian stock exchange, B3, has only around 150 companies with reasonable liquidity for funds to invest. Ibovespa is made up of just 83 of these companies.

Consider that each fund invests in 10 to 20 shares, that is, an average of 15 companies.

If you have a portfolio with 5 or more equity funds, you may have purchased all of the Ibovespa shares.

If you have 8 stock funds, your result will certainly be similar to that of just buying the Ibovespa, but with a higher cost.

If you only want to have exposure to Ibovespa, it would be better to invest in a passive fund or ETF of the index itself, as the result would be similar, but at a lower cost.

Your objective of investing in active stock funds is to try to obtain a gain greater than that of the Ibovespa. However, it will hardly be possible to obtain considerable gains in excess of the Ibovespa with more than 5 Brazilian equity funds in a portfolio.

The exception would occur if they are funds that invest in BDR or internationally.

Therefore, diversification with more than 4 Brazilian equity funds in a portfolio may be an excess dose of the medicine. Considering good diversification, an optimal number would be between 2 and 4 stock funds.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

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