Unsystematic risk can be nearly eliminated through investment diversification. Unsystematic risk is specific to an individual investment or industry and is not correlated with the market. Therefore if you don’t participate in diversification you are taking unnecessary risk that you will not be compensated for.

Under and Over Diversification

There are large benefits to diversification in small numbers. In other words, three stocks is much better that two, and six stocks is much better that three. But with each additional investment added the marginal benefits decrease.

Most studies show that diversification is optimized at between 15 and 30 individual investments. Further diversification yields a smaller and smaller benefit. At some point the costs become greater than the marginal benefits of further diversification.

Over Diversification occurs when the marginal benefit (reduced risk) of adding additional investments to a portfolio becomes less than the marginal loss (reduced returns).

Over diversification reduces quality, leads to average performance, and can increase your costs. So while under diversification can be devastating; over diversification should also be avoided too.

For instance we know that adding an 11th stock to a 10 stock portfolio would provide a large benefit. But would adding 100 stocks to a 1000 stock portfolio give you the same benefit? No, it would not. The benefits would be small but the costs might be great.