Diversify! Diversify! Diversify!
Many financial pundits vouch for a diversified mutual fund portfolio, they advise to steer clear from over-diversification. So when does your portfolio become overdiversified? How to spot an over diversified portfolio and do you mitigate this? You will get an answer to all these questions further ahead in the post. Read on!
In this article
- What Does Portfolio Diversification Mean?
- What is Over-Diversification?
- What Are The Signs Of Over-diversification?
- How to mitigate mutual fund portfolio over-diversification?
- The Bottom Line
What Does Portfolio Diversification Mean?
The most straightforward example to understand diversification is by using the example of a cricket team. A cricket team will never have only batsmen or bowlers as all eleven players. In fact, even the batsmen and bowlers within the team will be of different types. This is because a team requires different skill sets to perform well.
The beauty of investing in mutual funds is that you can invest a few thousand rupees in one mutual fund scheme and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio in stocks, you might have to buy many individual shares of a company across sectors and based on company size.
This can expose you to more risk than you would find in mutual funds.
A mutual fund scheme allows for diversification between many different stocks while also allowing for diversification between various sectors of the economy and class of assets such as bonds, cash, or commodities like gold and other precious metals.
This diversification allows investors to reduce the risk of one particular stock or sector or asset class
But it is important to remember that no matter how diversified your mutual fund portfolio is, your risk can never be eliminated.
You can reduce the risk associated with an individual mutual fund selection, but there are inherent market risks that affect nearly every portfolio if it is over diversified. Not every amount of diversification can prevent all kind of risk.
What is Over-Diversification?
Over-diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk.
When adding individual investments to a portfolio, each additional investment lowers risk but also lowers the expected return.
For example, let us look at two extremes;
- Owning 1 type of mutual fund: If you own just one mutual fund scheme, your expected gain is very high but so is your risk. Your entire portfolio performance would ride on that one mutual fund. It’s easy to understand the benefit of adding; going from 1 mutual fund scheme to two.
- Owing 10 types of mutual fund: Each time an investment is added to the portfolio it lowers the risk of the portfolio, but by a smaller and smaller amount. At the same time, each additional investment lowers the expected return and you reach the number of investments where the marginal benefit of risk reduction is smaller than the decrease in expected gains.
What Are The Signs Of Over-diversification?
Now that you understand the motives behind the diversification, here are a few signs, that you may be undercutting your investment performance by over-diversifying your mutual fund portfolio.
How to mitigate mutual fund portfolio over-diversification?
I would recommend goal-based investments when it comes to mutual fund investments.
You should invest in debt oriented mutual fund schemes and bank deposits to achieve your short term goals that need to be met in 1-3 years.
You can park a part of your emergency fund in liquid mutual funds and keep the rest of the emergency money in bank fixed deposits.
Also, you can consider investing a lumpsum amount in equity-oriented mutual funds if you have an investment horizon of 10-25 years.
If the investment horizon is medium, say, 3-10 years, you can stagger your investments over a few weeks or months based on the quantum of your investment.
The ideal number of mutual funds to be present in your portfolio depends on factors like your investable amount, investment goals and risk profile.
While the number of mutual funds you should hold is subjective, there is a basic cut off for most people. As a rule of thumb, 3 funds are enough for your portfolio to be adequately diversified.
For equity mutual funds, you should not have more than 3-5 funds in your portfolio which are spread across different market segments and fund management styles.
The Bottom Line
Diversification is like ice cream. It is good, but only in moderation.
The common consensus among veteran investors is that a well-balanced portfolio with approximately 3-4 type of mutual funds diversifies away the maximum amount of market risk.
Owning additional mutual fund type takes away the potential of big gainers significantly impacting your bottom line, as is the case with large mutual funds investing in hundreds of stocks.
In the words of the famous investor, Warren Buffett, “Over-diversification is only required when investors do not understand what they are doing.”
In other words, if you diversify too much, you might not lose much, but you won’t gain much either.
At last, it is worth remembering that diversification is not about numbers, but investing across a range of companies, sectors and assets classes by using mutual funds as the instrument.