Over Diversification in Investing: Why Too Many Stocks Can Be a Costly Mistake

Something that pretty much every investor learns on day one of investing is this:
“Diversification is the only free lunch in investing.”

But investors often take this advice too far.

Instead of owning enough stocks to decrease their risk, they end up copying an index fund. They hold so many stocks that their investments are diluted. On top of that, they spend hours doing research, reading earnings reports, monitoring markets… All to just average out!

This is called over diversification, and it can be incredibly detrimental to you if you’re just starting out with growth investing.

In this post, I want to cover why over diversification caps your wealth-building potential. How many stocks is enough anyways? And why some of the best investors in the world practice concentration.

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What Is Over Diversification?

Over diversification is when you have so many positions in your portfolio that adding more reduces very little risk but continues to water down returns.

1. Investor A has 8 growth stocks he researched himself.
2. Investor B has 55 stocks from all different sectors.Who will win the portfolio race?

Most of the time investor A.

Why’s that?

Investor B cuts his winners so small they don’t significantly impact his overall portfolio.

Picture yourself finding a ten-bagger stock.

If that stock is 1% of your portfolio a 10x return only moves your portfolio performance by about 9%.

Isn’t exactly life changing is it?

But what if that ten-bagger was 15% of your portfolio? Boom. Over diversification is attacking you.

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Why New Investors Often Over Diversify

Lots of new investors mistake diversification for safety.

They think:

• More stocks = safer
• More sectors = safer
• More countries = safer

So they continually open new positions when they have extra cash.

Pretty soon their portfolio looks like…

• 3 AI stocks
• 4 semiconductor stocks
• 2 banks
• 3 healthcare stocks
• 5 REITs
• 4 consumer companies
• 6 ETFs

A few speculative positions

Before they know it, they have 30-50 positions.

By that time, it’s hard to keep up with all the companies.

Even worse, they know little about most of them.

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The Real Risk Is Not Volatility

Risk is defined by many investors as price swings.

Risk is defined by smart investors differently.

Risk is:

• losing part of your capital forever
• owning companies you don’t understand
• overpaying for growth
• buying the hype story instead of a fundamentals story

A portfolio of 50 companies you don’t understand may not be less risky than a portfolio of 10 companies you understand very well.

It could be FAR MORE RISKY.

If you can’t explain to yourself:

• how the company makes money
• why it will continue to make money
• what’s driving revenue growth
• what’s the outlook for the industry

then owning more of that nonsense won’t decrease your risk.

It will increase your risk.

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Warren Buffett’s View on Diversification

Warren Buffett is one of the few investors who likes to talk about diversification…A lot.

Here’s one of his favorite quotes on the topic:

“The rule about not putting all your eggs in one basket is great advice—unless you know for certain that one basket will win and others will lose. Diversification is protection against ignorance.”

Although Buffett sees value in diversification for the average investor, he also feels if investors understand a business they can take advantage of concentration.

If you look back at Berkshire Hathaway’s biggest winners over the years you will notice many of them were concentrated positions like:

• Apple Inc.
• Coca-Cola
• American Express

These stocks became large enough to move the needle for Buffett because they were concentrated positions in his portfolio.

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Why Growth Investors Should Avoid Excessive Diversification

Growth Investing is NOT Index Investing.

You Don’t Want To Own Every Company.

You want to own exceptional businesses That can return multiples.

Think….

• AI
• Cloud
• Robotics
• Space
• Driverless
• Semiconductors

Time after time over history….the majority of wealth created in the stock market comes from a small fraction of stocks.

Countless studies demonstrate that the majority of stocks underperform market indexes over their life.

Only a few BIG winners drive total market returns.

If you have too many losers in your portfolio….your winners can’t do enough to matter.

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The Math Behind Over Diversification

Let’s look at two portfolios.

Portfolio A

• 10 stocks
• All equal weighting
• 10% in each position

A single stock turns into a 10-bagger.

Impact: 10% x 10 = 100%

Remember this portfolio only has ten stocks. One big winner can double your money!

Portfolio B

• 50 stocks
• All equal weighting
• 2% in each position

A single stock turns into a 10-bagger.

Impact: 2% x 10 = 20%

Same stock picks. Same results, just diluted.

The investor IDENTIFIED the big winner just like his peer.

Yet his portfolio won’t come close to doubling.

Over diversification is the hidden cost.

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The Time Problem Nobody Talks About

If you invest in stocks, you have to keep track of them.

You have to follow:

• Company earnings reports
• Management discussion
• Competitors
• Industry news
• Valuation shifts

Are you following:

10 stocks

or

50 stocks?

The latter will suck up a lot more time.

A lot of investors become “jacks-of-all-trades” and know a little about many companies. Instead of experts on a few.

Often depth of knowledge trumps breadth of knowledge when making investments.

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How Many Stocks Do You Actually Need?

There isn’t a magic number.

That said, research has shown that you gain most of the diversification benefits after quite a few stocks.

Many academic studies have found that owning about 15-25 stocks that are moderately uncorrelated eliminates most company specific risk.

After that point, there are diminishing returns.

Here’s a quick breakdown:

5–10 Stocks

Ideal for seasoned investors who are highly confident in their picks.

10–20 Stocks

Sweet spot for many active investors.

Allows you to diversify while still maintaining enough capital in positions for movement to matter.

25+ Stocks

Tends to start creeping into over-diversification territory.

50+ Stocks

Starts to feel like you’re just running your own version of an index fund.

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When Diversification Makes Sense

Again, this article is not saying you should avoid diversification altogether.

I believe diversification is smart if:

You’re a Beginner

New investors are still developing their business analysis skills. Broad diversification can help hedge your errors.

You Don’t Have Time

If you don’t have the time to research companies, then ETFs might be a better route.

You’re Close to Retirement

When you’re close to retirement you care more about preserving your capital than growing it as much as possible. So diversification can help reduce your risks.

You Like Passive Investing

Index funds are still one of the best wealth creation tools for the average investor.

The real difference is knowing if you’re trying to:

• Track the market Returns that match the overall market.
• Beat the market Returns that exceed the overall market.

Your strategy should reflect which you’re trying to do.

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A Better Framework for Growth Investors

Rather than asking yourself:

“How many stocks should I own?”

Ask yourself:

“How many companies can I truly understand?”

For most people, the answer is shockingly few.

A realistic portfolio may look like:

Core Positions (60%–80%)

Your best ideas, ones you have the highest conviction in.

Examples:

• AI infrastructure
• Mega/near-mega software companies
• High quality compounders

Satellite Positions (20%–40%)

Smaller speculative bets.

Examples:

• Emerging technologies
• Turnarounds
• Early stage growth companies

This allows your winners to move the needle on your returns while still being sufficiently diversified.

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The Biggest Mistake: Diversifying Away Your Best Ideas

Among the most frequent investing errors is discovering a great company and then not investing enough money to it.

Entrepreneurs sweat for months over:

• Revenue growth
• Margins
• Management
• Competitive advantages

And then only invest 1% of their portfolio. If conviction is that high, scale should follow.

Conviction, of course, needs to be deserved. It’s earned by doing your homework, not by following your heart.

But by watering down every idea by the same amount, investors water down their best ideas too.

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Final Thoughts

Diversification is good.

Too much diversification is bad.

If you’re early in your growth investing career, you should be focused on learning, building conviction, and finding great businesses.

40, 50, 60 stocks might make you feel safe, but you’ll likely end up just mediocre. You’ll spread yourself too thin. You won’t be able to really know your companies. You’ll have fewer big winners.

Warren Buffett didn’t become wealthy by owning everything.

He became wealthy by finding a few winners and letting them compound.

Most people won’t be able to beat a well researched portfolio of 10-20 stocks they’re high conviction on by having dozens of positions they can’t follow.

Remember..

Diversification lets you be wrong

Concentration lets you be right

You just have to know which you are.

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