Over-diversification is an aspect of portfolio building where investors usually end up adding an unnecessary number of stocks or mutual funds to the portfolio. Investors tend to add assets that might not add any significant value.
For instance, too many mutual fund schemes of the same sector, investing in all the mutual fund schemes of only one particular fund house, investing in numerous large-cap schemes, etc.
The drawbacks:
The three biggest perils of over-diversification are overlapping of portfolios, inability to track performance and below average returns. An army of 70 underperforming stocks can significantly dampen the expected returns when bundled with 10 market soaring stocks.
On various occasions, investors tend to accumulate minuscule corpus in varied overlapping mutual fund schemes which consist of identical stocks, thus exposing the portfolio to fatal risk in case of under-performance.
LESS IS MORE
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- Over-diversified portfolio guarantees lower returns for no reduction in risk
- Three biggest perils of over-diversification are overlapping of portfolios, inability to track performance and below average returns
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How many stocks or schemes are enough to build a diversified portfolio?
Just 15–20 stocks of different sectors or a consolidated mutual fund portfolio of 5-6 schemes can suffice the need of a well-diversified portfolio. Since the market risk (systematic risk) cannot be diversified, lowering the expected returns by adding more funds or stock from a portfolio is a futile exercise. However, an investor also needs to ascertain his risk profile, time horizon, asset allocation strategy, and financial goals before making any investment decisions.
Time-consuming:
A highly over-diversified portfolio is more time consuming to track and follow. It does not make an investor lose focus on how the money is invested but also makes it extremely difficult to review a plethora of investments on regular bases or track performance in order to make necessary changes in the strategy. A consolidated portfolio shows the investors conviction in the funds or stocks already in the portfolio and has a significant impact on meeting his financial goals.
So what should investors do? Diversified investments promise less risk but an over-diversified portfolio guarantees lower returns for no additional reduction in risk. An investor thus needs to inculcate a suitable asset allocation strategy which is linked to the financial goals and risk profiling of the individual.
Core and satellite approach may be adopted wherein an investor needs to inculcate a suitable asset allocation strategy which is linked to the financial goals and risk profiling of the individual. The core forms the maximum portion of the portfolio which is linked to an individual's long term goals and remains intact during the investment term. Satellite forms the remaining portion of the portfolio which can be approached in a tactical manner to make gains from the market opportunities.
The writer is founder and CEO, TBNG Capital Advisers
