Diversification: How Much Is Too Much?

Human nature and behavioral biases affect nearly every aspect of life. One of those common tendencies is to tell ourselves, “If a little bit is good, then more is better.”

With the proliferation of modern portfolio theory (MPT), diversification has become a bedrock of portfolio management, a seemingly foolproof strategy for mitigating risk. Generally, the objective of diversification is to lower portfolio volatility and increase risk-adjusted returns. However, actual results may surprise investors.

Studies show that if active managers would have invested solely in their highest-conviction ideas, the resulting concentrated portfolios would have achieved higher absolute and risk-adjusted returns (see chart below).