October 6, 2008

Dangers of over diversification


Diversification is necessary and even essential but can too much diversification be a bad thing? Is it better to own 100 stocks rather than 10?

When you diversify your portfolio, you are attempting to reduce your exposure to risk by investing in various companies across different sectors, industries or even countries. Though diversification is no guarantee against loss, it is a prudent strategy to adopt and there are many studies demonstrating why diversification works. Put simply, by spreading investments across various sectors or industries with low correlation to each other, you can reduce price volatility due to the fact that not all industries and sectors move up and down at the same time or at the same rate. This provides for a more consistent overall portfolio performance.

The million dollar question now is: how many mutual fund schemes should one own to be diversified but not over-diversified? It is better to own five rather than one mutual fund? At what point does adding more funds to your portfolio cease to eliminate risk?

Why diversify?

To begin with, let us define risk. Risk is usually measured by looking at volatility. The more volatile the asset, the riskier it is. Volatility implies how sharply a stock or portfolio moves within a period of time. Most of us believe that risk is proportionately reduced with each additional stock in a portfolio, when in fact this is not the truth. There is strong evidence that one can only reduce the risk to a certain point after which there is no further benefit from diversification. One can diversify away much of the risk associated with holding a single asset but one cannot diversify away the risks of simply being in the market.

Limitations of diversification

It's important to remember that no matter how diversified your portfolio is, your risk can never be shrunk down to zero. You can reduce risk associated with individual stocks (what academics call unsystematic risk), but there are inherent market risks (systematic risk) that affect nearly every stock. No amount of diversification can prevent that.

Costs of over-diversifying?

The biggest advantage of investing via the mutual fund route is diversification. Hence, do we need to buy a number of mutual funds and keep adding to those numbers to achieve ‘diversification’?  Fund investing is different from stock investing. A mutual fund is a risk diversifier in itself. It invests in a basket of equities, enabling one to earn the benefits of investing in a diversified portfolio with even a small outlay. If you go for further diversification with mutual fund holdings, there is a distinct possibility that the very purpose of the investment is nullified.

The risk of holding a single financial security is removed by diversification. But, in case of over diversification, investors diversify so much that many times they end up with investing in funds that are highly related and thus the benefit of risk diversification is ruled out. Some funds in your portfolio may be laggards or underperformers and this brings down the performance of the entire portfolio.

Diversification also involves certain costs like more paperwork and higher transaction costs. It is easier and cheaper to manage and track five or six investments rather than fifty.

End note

Equity investments give healthy returns in the long run. No other asset class can match them in terms of liquidity, returns, and convenience of investing. Hence have a systematic approach to investing in a basket of time-tested funds; this is the best way to build a solid portfolio.

In conclusion, diversification is a means to remove some of the risks associated with holding a single asset or ‘putting all your eggs in one basket’. One can diversify away much of the risk associated with holding a single asset but one cannot diversify away the risks of simply being in the market. In the words of Warren Buffet “Wide diversification is only required when investors do not understand what they are doing.”

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