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Peter Lynch originally coined the term "diworsification" in reference to companies that expanded into business lines beyond their core competencies. Today, diworsification is more commonly used to describe portfolios that try to engage in diversification for diversification's sake when it might not be needed, or might be downright bad for the portfolio.
What's that? You can diversify too much? Yep.
There are two main types of over-diversification: 1) Holding too many investments, and 2) Holding multiple investments with underlying securities that overlap.
Holding Too Many Investments
If you are a stock picker, just how many companies can you follow? If your goal is to make the most amount of money, then in theory you would just hold your top pick. Of course we know that unforeseen circumstances can derail the best of investment theses so we choose not to put all our eggs in one basket. We spread them around. The opposite end of that spectrum is to hold everything. That's going to give you index-like returns. Might as well hold an index fund then.
Within any given market, we have systematic risk and non-systematic risk. Systematic risk is tied to the general ebb and flow of the overall market. Non-systematic risk is independent of the market - think of it as the individual business risk of any given company. We can diversify away the non-systematic risk and studies have shown that between 20 and 40 holdings ought to do the trick. Beyond that you have diminishing utility, expressed as the variance in the portfolio approaching an asymptote (the level of systematic risk). The non-systematic risk you eliminate by increasing your holding from 40 to 60 probably isn't worth the trade-off of all the extra research you have to do.
If you are an indexer, you don't have to worry about holding hundreds of securities in the portfolio. You're not researching any of them and there is no extra research being done on your part.
Holding Overlapping Investments
I don't know a single adviser who hasn't met a prospective client who has held multiple Canadian equity mutual funds that pretty much all hold the same thing. Simply look at the top 10 or 25 holdings for each fund - a real shocker is that the holdings and weighting of some of the largest "actively" managed funds are surprisingly similar to the index. Either switch to a less-expensive index fund or find an active manager who is sufficiently different from the index.
Diversification is good until it becomes diworsification.
Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.