Quora Answer: When Does Diversification Become Excessive Enough to Prevent a Portfolio from Beating the Market?

The following is my answer to a Quora question: “When does diversification become excessive enough to prevent a portfolio from beating the market?”

Peter Lynch coined the term for this in his 1989 book, One Up on Wall Street.  He called it diworsification.  Piling up holdings that add nothing but the illusion of safety.

John L. Evans and Stephen Hunt Archer ran the first serious test of this in 1968.  They built portfolios of random stocks and tracked volatility as each new name joined.  Most of the reducible risk disappeared by ten to fifteen stocks.  The curve flattened hard after that.  Benjamin Graham, in The Intelligent Investor, put the practical range at ten to thirty companies.  Dr Meir Statman’s later research pushed the theoretical optimum past 300 stocks, depending on the model used.  Nobody agrees on the exact number.  Everyone agrees the benefit runs out long before most portfolios stop adding names.

The Australian market gives a clean test case.  Over ten years, the S&P/ASX 100, the top 100 companies, returned 179.82 per cent total, an annualised 10.83 per cent.  The S&P/ASX 300, holding three times the names, returned 174.55 per cent, an annualised 10.62 per cent.  Tripling the holdings produced a lower return, not a higher one.  The extra 200 names added complexity and cost.  They did not add performance.

Own enough stocks, and a portfolio starts behaving like the index it was built from, at a higher fee.  Own too many stocks, and your performance matches the benchmark.  At that point, paying a fund manager is pointless.  Buying the index outright is cheaper and does the same job.

Correlation makes this worse than the stock count alone suggests.  Thirty stocks can still be diworsified if all thirty move together.  Adding a twentieth energy company to a portfolio already holding nineteen does not diversify anything.  It adds a name, not a genuine risk offset.

A portfolio has crossed into diworsification the moment adding another position stops changing the outcome.  Test it directly.  Remove your smallest ten holdings and check whether the portfolio’s return and volatility profile actually shifts.  If it does not, those ten positions were never earning their place.  They were paperwork, dressed up as prudence.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code