Investors Should Consider the Downfalls of Too Much Diversification

One of the things you first learn about investing is the importance of diversifying your holdings so that you minimize firm-specific risk so that all you are left with is the market-related risk that cannot be diversified away. Typically you would buy a dozen stocks to achieve diversification and that would require a lot of capital and consume a lot of commissions. However, in today’s investment world that model doesn’t work anymore.

With so many options to buy ETFs you can get a very good mix of holdings without having to make many trades. In fact you can go one step further and get an index fund, iShares S&P/TSX 60 Index Fund (TSX:XIU), which does a good job of mirroring the TSX and you only have to buy one stock to achieve this.

The disadvantage of mirroring the market is that you are limiting the returns you can achieve right off the bat. If you invest in a blue-chip stock like the Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) you are benefiting from a strong growing dividend plus a stock that will often outperform the market and earn you a stronger return in the end. There are exceptions to this of course, but generally if the market is doing well, so are the banks and other high-quality stocks.

If you just want to invest your money safely without having to dig into a lot about a company’s financials then an index fund will work for you. However, by selecting a few strong stocks to invest in you give yourself better odds for success. Diversification will minimize your risk, but it’ll also minimize your potential returns.