Why You Should Avoid Portfolio Overdisification?

Mutual funds already possess some built-in diversification. One equity mutual fund might own hundreds of stocks, meaning one owns thousands of different companies. The judicious selection of three to five funds spread across categories is enough for most investors to create a balanced portfolio. Still, many investors believe owning more funds represents lower risk.

If you maintain too many funds that generally invest in the same asset classes or sectors, you will unnecessarily create overlap, which would then mean different funds would possess the same assets. Assume two large-cap funds buy the top-performing stocks of HDFC, Infosys, or Reliance Industries. Both have reasonable individual returns but may not make a powerful play on your portfolio together due to overlap.

5 Reasons Why You Should Not Overdiversify Your Portfolio

Given below are the major reasons why one should not over-diversify their portfolio:

• Dilution of Returns

While diversification can help manage risk, over-diversification can dilute your potential returns. When you spread your investments too thin, no single asset or sector has the chance to significantly move the needle on your portfolio's overall performance. Instead of benefiting from a few high-growth opportunities, your returns are "averaged out" across many positions, including underperformers.

• Increased Complexity

Managing a portfolio with too many holdings can quickly become overwhelming. From tracking performance to rebalancing regularly, over-diversification increases the complexity of managing your investments. Additionally, you might find yourself paying higher fees due to more transactions, making the process more time-consuming and costly.

• Overlapping Investments

Over-diversifying often results in overlapping investments, where you essentially hold similar types of assets that don’t provide true diversification. For example, if you own several index funds or ETFs that track the same sectors or markets, you may not reduce risk as effectively as you think. Instead of broadening your exposure, you’re just duplicating it.

• Missed Growth Opportunities

A concentrated portfolio with a few high-conviction investments has the potential to outperform a highly diversified one significantly. By owning too many assets, you may miss out on opportunities to invest in higher-growth or niche assets that could drive more substantial returns. 

• Inefficient Use of Capital

When you over-diversify, some of your capital is inevitably tied up in underperforming or stagnant assets. This means your portfolio isn’t working as efficiently as it could, and you're not taking full advantage of your investment potential.