When you purchase a mutual fund or ETF you are buying a share of a pool of specific assets that might include stocks and bonds in a variety of sectors and countries. An index mutual fund or ETF portfolio can give you all the diversification you need in as little as one to four core funds covering your major asset classes.
However, many investors, not satisfied with a minimum number of funds, start adding more and more to their portfolio – dividend stocks, REITs, value stocks, small cap, large cap – thinking they are increasing their diversification.
Do you hold too few eggs in your basket?
How can you tell if your portfolio is properly diversified? Proper diversification maximizes your profits while minimizing risks. A Canadian equity fund may have good diversification in the Canadian equity market, but if you start adding variations of Canadian equities you might find you are duplicating your holdings.
For example, say you hold Vanguard FTSE Canada All Cap ETF and then decide to “diversify” with dividend paying stocks and purchase iShares Canadian Select Dividend Index ETF. By drilling down to the fund holdings, you find that you are doubling your holdings of certain stocks that are common to each fund.
In this example, half of the funds top holdings are duplicated. If instead you bought iShares Core S&P/TSX 60 Index ETF, you would find nine of the top ten holdings duplicated.
Related: Is my two-ETF portfolio too simple?
Not only are you paying twice for the same holdings through the funds MERs, you are increasing your risk profile by having too much exposure to a smaller handful of stocks. (In the example above, Canadian banks would make up almost half of your portfolio.)
Take a look at the composition of your funds, especially if you also hold individual stocks. If you decide to purchase another fund, compare the holdings to avoid falling into the under diversification trap.
If you find you have too much concentration in one area, search for funds that aren’t as closely correlated. But, be careful not to go to the other extreme of over-diversification, which can increase costs and ultimately dilute overall returns.