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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.” |
