Policies, Codes & Other Documents
‘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.
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.
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.
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.
Here are a few disadvantages of over-diversification:
Here are a few tips to avoid the pitfall of over-diversification:
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.
Policies, Codes & Other Documents