There is no such thing called ‘overdiversification’

Some phrases annoy me whenever I hear them. ‘Rat race’ is one: it’s a disrespectful, polasing name invented by people who just want to sell their stuff or idea. Regular people need not repeat that slur.

‘Hard earned money’ is another: money deserves just as much respect irrespective of how easy a time you had earning it.

The most recent in that list is ‘overdiversification’. Hearing it annoys me because overdiversification is not a real thing.

Let’s say you hold N assets in your portfolio. Adding another asset that is positively correlated with any other existing asset does not yield much of a benefit. Example: You already hold UTI Nifty 50 index fund. Adding ICICI Nifty 50 index or a large cap equity fund is not going to give you much of a diversification. By adding this fund you are not overdivesifying, but you are just adding clutter. Portfolio clutter indicates a real problem, but that problem is not “too much diversification”. Portfolio clutter is a different problem.

Let’s say you hold an Indian equity mutual fund (it doesn’t matter which category). Credit risk debt funds have low correlation with equity, so adding it will give you diversification benefits. But most retail investors are better off without such credit risk in their portfolio. This diversification doesn’t help because it’s just a bad asset to hold. The drawbacks of such a risky asset easily overshadow the benefits. This is just poor asset selection rather than “too much diversification”. (Or you can call it “diworsification” if you feel cute.)

Overdiversification is just the wrong name people use to describe one of these unrelated problems.

If you think this post is making a pedantic argument, you’re right. Cribbing about the choice of words people use is indeed pedantic. But pedantry has its uses, too. Calling things by their correct names is crucial to avoid misunderstanding. I’ll let you decide whether or not to correct someone using the word overdiversification, but you should know that people often use this word to describe very different problems.