‘Diversification’ as we know it is the only free lunch in the investment world. It is an effective measure to reduce risk over the long haul. The right amount of diversification could lead to your portfolio not suffering too much during an unforeseen downturn in the markets. It also irons out volatility in the long term and ensures that you reach your financial goals with the minimum amount of hiccups.
However, like there are always 2 sides to a coin, overdoing diversification can lead to a highly fragmented portfolio. There are some disadvantages to holding a highly fragmented portfolio, such as manageability, alignment to financial goals is tough etc. Here are tips on how you can attain the ideal diversification without going overboard.
What is portfolio diversification?
The concept of diversification can be traced back to Markowitz’s modern portfolio theory, where he emphasises the need to add uncorrelated or negatively correlated assets to the portfolio. Although it is indeed tough to find perfectly negatively correlated assets (which move in opposite directions) in real life, we should make an earnest effort to add low-correlation assets to our portfolio.
What is the best way to diversify your portfolio?
To achieve a well-diversified portfolio, start by looking for low-correlation assets. The best way to diversify a portfolio is to select assets that align with your risk appetite and return expectations. Spreading your investments across different assets can help you create an optimally diversified portfolio. One can begin with investments in equities, fixed income and further diversify into areas like foreign markets, commodities (gold or silver), real estate, etc. ETFs and mutual funds are the ideal way to diversify your portfolio. There is an inherent element of diversification which exists in mutual funds, as the funds are invested across a pre-determined universe of stocks. You mustn't go overboard on choosing too many funds within the same category.
For example, whilst designing our mutual fund portfolio, it makes sense to add mutual funds across different market caps as each of these categories has different characteristics. Large-cap mutual funds tend to perform relatively well during a market downturn. They tend to hold value during bear markets, whereas mid-cap and small-cap funds tend to perform well during a bull market, provided they are managed well. Similarly, one can consider adding equity mutual funds alongside Gold ETFs or gold mutual funds, as they tend to have a negative correlation. During inflationary times when equity tends to slide, gold continues to hold value.
What is “over-diversification” of your investment portfolio?
Given this scenario, there is a high possibility of going overboard on your diversification if you add too many funds of the same category or opt for a very small SIP across multiple schemes with the same underlying objective.
Typically, funds within the same category often look alike with a minuscule difference as they tend to invest in stocks from the same universe. You also need to remember that the fund manager is already diversifying, and hence, investing in multiple funds within the same category could potentially lead to over-diversification as the underlying stocks in these schemes could be similar.
Perils of over-diversification:
Here are a few disadvantages of over-diversification:
- Lower returns at higher levels of risk:
Diversification helps reduce systematic risk. There is no benefit beyond a point. Hence, by over-diversifying, you end up lowering the returns per unit of risk assumed.
- Extreme fragmentation:
Over-diversification leads to a highly fragmented portfolio which becomes very tough to manage. Tactical and strategic realignment would be more of a consolidation effort rather than to increase returns.
- Difficulty in alignment with financial goals:
An over-diversified portfolio is very tough to be aligned with your financial goals. Often, you would have innumerable avenues to liquidate to meet any financial goals, which becomes cumbersome.
How not to over-diversify
Here are a few tips to avoid the pitfall of over-diversification:
- Review your portfolio and consolidate:
Monitoring your portfolio and reviewing it at regular intervals can go a long way in building a well-diversified portfolio which helps you attain your goals most efficiently. If your portfolio is spread across too many mutual funds or assets which are similar, then you can consolidate them to reduce the fragmentation.
- Add assets which complement your portfolio:
Any investment opportunity should not only be assessed for merits on its ability to deliver superior performance at lower risk levels but should also be assessed on its ability to complement your portfolio.
- Align your investment with your risk profile and financial goals:
Always align your investments with your risk appetite and financial goals. Any haphazard investment could be a sign of you falling slowly into the over-diversification pit. While it is important to add mutual funds or assets with low correlation to your portfolio, assess how much risk it could potentially bring down in your portfolio.
- Check on the manageability of your portfolio often:
Always check if your portfolio is well within manageable limits. If it seems like you have too many assets and funds to handle, then it may be time for some serious consolidation.
Hope this brief note helps you achieve optimal risk-adjusted returns. After all, that is the ultimate goal of diversification! You can always reach out to TATA Capital Wealth executives, who can help you with your journey of designing the ideal portfolio for you.
11 November 2022
5 mins read
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