When you get started on your investment journey, one of the most important decisions that you’ll need to make is choosing the investment options for your portfolio. The logical route is, of course, to identify your investor profile and pick investment products that align with your risk tolerance levels, your financial goals, and the investment horizon you have in mind. But when you’re deciding on the investment options to park your funds in, the question of diversification crops up.
How do you balance the fine line between diversification of investments and concentration of investments? And more importantly, which works best in the long term?
To resolve this, it’s important to begin at the basics and understand what diversification and concentration are, and how they work.
Diversification of investments
Diversification is essentially an investment strategy where you allocate your capital to a mix of different assets. The rationale behind this technique is that when you include a mix of different investment options in your portfolio, you minimize the risk associated with volatility in the financial market. In other words, even if a few of the assets in your portfolio don’t perform as expected, they will be set off by higher returns from other assets, thereby giving your portfolio an overall positive ROI.
Diversification is generally construed as asset allocation between different classes of investments, like debt, equity, gold, and more. However, diversification is also possible within a particular asset class. An example would help make things clearer.
Additional Read: How can a long-term investment approach help manage a crisis?
Diversification within an asset class: An example
For instance, let’s take an asset class like equity mutual funds. Now, it is possible to execute the diversification strategy at the level of this asset class too. If you’re a risk-friendly investor who chooses to invest in equity mutual funds, you can take your pick from different alternatives like the following:
- Small cap funds
- Mid cap funds
- Large cap funds
- Multicap funds
- Index funds
- Different kinds of sectoral funds
Similarly, if you choose another asset class like debt mutual funds, you’ll again have the option to diversify across different types like money market funds, income funds, banking and PSE funds and more.
The pros and cons of diversification
Now, if you choose to diversify your portfolio by including different kinds of equity funds or debt funds, you get to enjoy one key advantage. You get to level out the volatility and risk associated with the investment options in your portfolio. Diversification of investments ensures that even if one or few of the industries in which you’ve invested don’t perform well, the other segments in your portfolio can off-set those assets, thereby giving you the opportunity to earn good returns.
On the downside, diversification of investments could also end up diluting how you allocate your capital across assets, thereby leading to only average returns in the long run. In simple terms, diversifying too much can water down your profits. In the context of diversification at a particular asset class level, like equity mutual funds, it would also mean that by investing in too many funds, you could end up owning a portion of a majority of the market. There is also the possibility of an overlap of stocks (or debt instruments in the case of debt funds), which eventually dilutes your portfolio significantly. In the long run, this could affect your returns.
Concentration of investments
To avoid the pitfalls of over-diversification, concentration of investment is a strategy that comes in handy. As is evident from the name, concentration involves focusing on limited assets alone. This technique can be employed at an asset class level as well. The rationale behind concentration of investments is that it improves your chances of earning good returns if the investment options you choose perform well.
Concentration within an asset class: An example
To draw parallels, let’s take up equity mutual funds once again. If you were to execute the concentration strategy here, you would have to select, say 1 to 3 mutual funds to invest in, with as little overlap in stocks as possible. For example, you could choose to invest in either a large cap fund alone, or in a large cap fund and a pharma sector fund. This reduces the diversification, but it also minimizes the possibility of diluting your investments.
Additional Read: Best Investment Ideas to generate Passive Income
The pros and cons of concentration
The key advantage of concentration of investment options is that it increases the potential gains you can earn from your assets. By concentrating your investments in a few well-performing funds over the long run, your chances of earning high returns improves tremendously. As Warren Buffet put it, diversification may preserve wealth, but concentration builds it.
The downside to concentration, of course, is that it increases the risk. If the asset you chose doesn’t perform as expected, you could face losses.
The bottom line: Which approach wins in the long term?
In the context of mutual funds, concentration may be the better strategy in the long run, since every mutual fund is already diversified in its own way. Before deciding any approach for investment, investors need to take into consideration their investment goal, risk appetite, and investment horizon. To decide which strategy works best for you, you could take the help of good research and expert advisory to narrow in on a few quality funds, which will take care of the diversification requirement, but are also simultaneously concentrated enough to retain the possibility of generating high returns.
Tata Capital Wealth offers a variety of quality funds across categories like equity, debt, close ended, solution-based and hybrid options. You can take your pick based on your investor profile and put together a focused portfolio.