The Pitfalls of Overdiversification

Investment professionals typically agree that to help achieve long-term investment goals, diversification is a prudent strategy to adopt. Properly diversifying your investment portfolio provides more consistent overall portfolio performance. However, some investors and their financial advisors tend to overdiversify.

The main issue with over diversifying is that having too many individual investment positions can lead to extensive due diligence, complicated analyses, and performance that simply mimics a stock market index.

Overdiversifying can also lead to diworsification, which is the process of adding investments to a portfolio in such a way that actually worsens the risk-return trade-off. Diversification is good, but only in moderation.

Diversification in real estate

There is a myriad of ways for property investors to diversify their investment holdings by selecting more than one investment per asset class, industry, and geography. The more you diversify within these three categories, the closer you will get to the index. It would then be more efficient to just buy that particular index. While this may seem like a stock market analogy, property investment funds in the form of real estate investment trusts (REITs) and mortgage investment corporations (MICs) consist of a cumulative collection of real estate assets and function in a similar fashion to an index fund.

Property investment funds, whether it be a MIC or a REIT, may specialize in one particular geography, industry or asset class much like a stock index fund would. For example, a healthcare REIT may have all or the majority of their holdings concentrated in healthcare-related real estate assets. These could exist in the form of a private hospital or a small medical clinic.

A real estate investment fund may also have certain parameters when it comes to geographical allocation of investment holdings. Assets are both strategically and tactically allocated over particular geographies. Based on the fund’s macroeconomic outlook, they may wish to limit their market exposure within a particular region in which they are comfortable playing.

Portfolio balancing

Some individual investors may not necessarily have a framework for diversification of their portfolio or on what fundamental principles on which to invest. Research shows that many individual investors are unsophisticated “noise traders” who are subject to psychological biases and fads.

A noise trader is an investor who makes decisions about buying and selling assets without consideration for fundamental data. As a result, these investors generally follow trends, have poor timing, and overreact to market news. Apart from making less informed investment decisions, they often hold undiversified portfolios and trade speculatively and actively, which leads to poor investment performance. Such investors tend to sell low and buy high and don’t stay with their long-term investment strategy.

Maintaining each investment asset within the range specified in an investment plan requires rebalancing. Rebalancing is the process of realigning the weightings of a portfolio of assets. This involves periodically buying or selling assets in a portfolio to maintain the original desired level of asset allocation.

The primary goal of a portfolio rebalancing strategy is to mitigate risk. If an investor fails to rebalance their portfolio by increasing its allocation to an alternative asset class during a down market, they may miss out on the subsequent equity returns when underperforming assets take off. On the other hand, if an investor fails to rebalance their portfolio by decreasing their allocation to an alternative asset class during peaking market conditions, they may miss out on locking in gains before the market eventually declines.

The aforementioned scenarios are applicable not only to asset class reallocation but also apply to geography, industry and other sectors in consideration of diversification. During a down market, the retail sector may be suffering during tough economic conditions; however, the multifamily sector may be climbing with the increase in demand for rental apartments.

Overdiversification

Many investors tend to overinvest in diversification. According to various academics, the relationship between profitability and diversification is curvilinear (The Relationship Between Diversification Strategy And Organizational Performance, Science Direct, 2013). Meaning, at low levels of diversity, a positive correlation exists between profitability and diversification, and at high levels of diversity, the relationship is negative.

This indicates that a property investor or investment firm can diversify profitably up to its optimal limit. After this point is reached, the costs outweigh the rewards of additional diversification, so it doesn’t pay dividends to diversify any further. Every investor and firm has a limit to how much they can diversify, but the optimal point differs relative to their internal resources.

By focusing rather than diversifying, efficiency and profitability increase. An investment firm’s organizational structure and investment strategy should be designed in such a way as to facilitate the firm’s chosen strategy. If a firm chooses to continually diversify, they are diluting their focus and hence, risk erosion of its profitability. For example, a small real estate fund that is comprised of industrial, retail, residential, and construction assets scattered across multiple countries is spreading thin the scope of their expertise and management capabilities.

Summary

Instead of investing in individual property, an investor can invest in pooled investments, such as a mortgage investment corporation (MIC), to gain the benefits of diversification and let professional managers handle the investments for them.

With CMI, the real estate portfolio is largely comprised of residential properties, with all property being located in Canada. All the assets follow strict investment guidelines that are within the parameters of their extensive expertise. Unlike some large investment funds that lump everything together, where you may find “poisonous” assets, CMI’s asset pool is not a mixed bag full of potential surprises.