In the investment world, the old saying, "Don't put all your eggs in one basket," is often used as a reminder of the importance of diversification. While it is generally accepted that spreading investment risk around through the use of different types of investments is a prudent strategy, can an investor be too diversified?

"When it comes to investing, you can have too much of a good thing," says Dan Candura, president of Penny Tree Advisers in Braintree, Mass.

Financial industry experts agree that overdiversification can actually thwart your investment goals in the long run, as too many securities or mutual funds can diminish portfolio performance, increase costs and create an overwhelming amount of work for advisers and investors.

The perfect investment recipe
Candura says diversification is like cooking. "You can mix a bunch of ingredients in a pot -- like onions, tomatoes, garlic or meat, but the end result can turn out very differently depending on the proportions," he says. "Everything may be necessary, but if you put in too much garlic, it can ruin the dish."

It's the same for investing as it is in cooking; if you want your ingredients to turn out the way you intend, the key is to follow a recipe. In investing, asset allocation is the recipe, Candura says.

Asset allocation is key
Creating a proper asset allocation is the first step in determining the right amount of diversification, according to Pat Swanson, Iowa State University extension specialist. "By having an asset allocation plan, you are able to look at your time horizon, consider risk tolerance, and have a collection of stocks, bonds and cash that will help you meet your investment goals."

The way to maximize returns while minimizing risk is to invest across different sectors, countries, asset classes or other criteria, says Jim Flinchum, president of Bay Capital Advisors in Virginia Beach, Va.

Because each of these asset classes reacts differently in various economic environments, having a variety should protect an investor during up and down markets; at any given time, one or more of your investments should perform well even if the others are down.

How can overdiversification hurt returns?
Unfortunately, many investors overdo diversification because there is a tendency to believe that if more is good, even more is better. "In investing, this is not the case," Flinchum says, noting that too much diversification can lead to mediocre performance.

Taken to an extreme, diversification can diminish returns simply because, if you have too many investments, the positive contribution of one won't be big enough to make a difference. For example, if a fund or security only makes up 1 percent or 2 percent of your portfolio, even a significant gain in that investment won't have a material difference in the overall portfolio.

Using Candura's cooking analogy, overdiversification is the equivalent of not using enough of one spice; you can't taste the difference at all because it just blends in to the whole.

Swanson says that if you have too many of a like kind of investment, such as a number of large cap stocks or mutual funds, your return will end up reverting to the mean, or average, and you would have been better off in a passive investment strategy, such as an index fund.

Flinchum argues that overdiversification can actually lead to returns that are worse than an index fund, because, "The portfolio might not be balanced to meet the index."

High costs
Candura cautions investors that overall performance can be further eroded by unforeseen trading costs or taxes associated with a portfolio that has too many holdings. If you are paying for trades or sales charges, managing an excessive number of stocks or funds can be expensive or prevent you from missing breakpoints.

Similarly, high turnover in a taxable portfolio can create an expensive tax bill at the end of the year if the consumer is not paying attention.

Management problems
Having too many securities or funds creates a real management problem, says Flinchum. He says that it is critical that either the investor or his or her adviser know every security or fund in the portfolio. "If neither understand it," he says, "it shouldn't be in there."

What is the right number of investments?
While the precise number of individual securities, mutual funds or other investments in a person's portfolio depends on a variety of factors, there are some generally held opinions of how much is enough. Countless studies have found that 15 to 20 randomly selected stocks are adequate to diversify a portfolio and protect against non-market-related risk. Additional securities do not help to reduce the total risk in the portfolio and tend to buffer the potential gains any one could add.

Swanson says the number can vary, but recommends no more than 10 to 12 stocks. She points out that those stocks need to represent different sectors, company sizes, and other factors in order to provide proper diversification.

Mutual funds are different than individual securities because they create diversification in and of themselves, says Candura. He points out that if you pick good funds in the first place, there is no need to have multiple funds with the same objective. Holding funds that have the same goals increases the probability that you'll own the same stocks in numerous funds, creating significant overlap or redundancy. It is more important to pick a top fund to correspond to each asset class.

Swanson suggests that a typical, novice investor start with just one or two funds.

"You need at least four asset classes represented," says Flinchum. He recommends small cap, mid cap and large cap domestic stocks, and some international exposure.

Each investor is different
The larger the portfolio, the more investments might be needed in order to create the proper allocation. In those instances, the asset allocation may be further broken down to include subcategories of asset classes, specialty asset classes, like commodities, or alternative investments. Even then, however, selecting the best investments in each category rather than loading up on too many investments that do the same thing is the key to creating a portfolio with adequate risk control.

"An investor needs good diversification but not excessive diversification," says Candura. "Don't add more complexity than you need." While you don't want to put all your eggs in one basket, you also don't need too many eggs.