The Diversification Dilemma: How Much is Too Much (or Too Little)?

When it comes to building a solid investment portfolio, diversification is often hailed as one of the most effective tools for managing risk. But like many things in life, too much—or too little—can be a problem. Even more confusing? Many investors misunderstand what diversification actually means.

The Risk of Over-Concentration

Many investors understand that diversification is important. Yet, it's common to see portfolios heavily concentrated in just a handful of individual stocks, sectors, or even countries. This lack of diversification can expose investors to significant risk. If a single company or sector underperforms, it can disproportionately drag down the entire portfolio.

A classic example is investing heavily in the company you work for. It may feel intuitive—after all, you know the business well—but it also ties your income and investments to the same source, compounding your risk. Similarly, some investors stick only to what they know, limiting their exposure to familiar sectors or regions and missing out on the benefits of broader diversification.

Emotional factors also play a role. In times of market excitement, it’s easy to chase hot sectors or stocks, leading to unintentional over-concentration just when caution might be most needed.

The Pitfall of Over-Diversification

While under-diversifying can be dangerous, over-diversification has its own downsides. This often occurs when investors hire multiple managers or buy into a variety of mutual funds. On average, a single U.S. equity mutual fund holds about 171 stocks. So owning just 10 such funds could mean exposure to more than 1,700 different stocks—and that’s not necessarily a good thing.

More isn’t always better. Over-diversified portfolios can be inefficient, difficult to manage, and more costly to maintain. There's also a risk of overlapping holdings, where multiple funds own the same stocks. In some cases, one manager may buy a stock while another sells it—resulting in contradictory positions and unnecessary trading costs.

The Misuse of “Diversification”

Not only can diversification be over- or under-done, it can also be misunderstood entirely.

Here are two common misuses of the term:

1. Diversifying Bank Accounts

Some people think diversification means spreading their money across many different banks. The problem with that strategy is it often overlooks the protections already in place. In the U.S., the FDIC insures bank deposits up to $250,000 per depositor, per institution, and per ownership category. Investment accounts are similarly protected through SIPC insurance (up to $500,000, including $250,000 for cash). Many brokerage firms also carry additional private insurance to cover even higher limits.

So unless your account balances exceed those insurance thresholds, spreading money across multiple banks doesn’t add meaningful security—and it can make managing your finances unnecessarily complicated.

2. Diversifying Insurance Policies

Another misconception is that diversification means having multiple types of insurance for the same purpose—especially with life insurance. For example, someone may hold both a term life and a whole life policy, believing it’s a safer, more diversified approach. But that may actually be overkill, depending on their personal situation.

Instead, life insurance needs should be determined using the L.I.F.E. acronym:

• L: Liabilities – Mortgages, credit card debt, and other financial obligations.

• I: Income Replacement – Especially for working individuals, this covers lost future income (e.g., 30 more years of income if someone dies at 30 and planned to retire at 60).

• F: Funeral Expenses – While these can be prepaid, they’re still an important consideration. Prepaying can also be a strategy for asset spend-down when qualifying for Medicaid.

• E: Education Funding – Covering the cost of college or other education for children.

  
  

When these four components are added up, they provide a clear estimate of how much life insurance is actually needed. Notably, the income replacement component decreases each year as retirement approaches. If other factors stay the same, the total need for insurance should shrink over time—not grow.

Whether you choose term life or whole life, either policy type can fulfill the total need. But having both may be redundant and unnecessarily expensive.

So What Does Effective Diversification Look Like?

True diversification means spreading your investment risk across:

• Asset classes (stocks, bonds, real estate, etc.)

• Sectors (there are 11 that make up the S&P 500)

• Geographies (U.S., developed international markets, and emerging markets, etc.)

  
  

It’s about constructing a portfolio that can weather different market conditions—not just collecting a random assortment of accounts, policies, or managers.

Final Thoughts

If you're unsure whether you're properly diversified—or possibly overdoing it—it may be time for a professional portfolio review. Understanding what diversification really means, and how to apply it effectively, is a key step in protecting your financial future.

About The Author

Marc Lowe is the Founder & President of In The Money Retirement Planning. He is a Certified Financial Planner and member of NAPFA National Association of Personal Financial Advisors, XY Planning Network & Fee-Only Network. He works with retirees and those approaching retirement. He has over a decade of experience helping these folks grow their net worth, organize their finances and build better lives for themselves and their families.

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