Excessively diversified portfolio will never give extraordinary returns

Diversifying too much may reduce risk, but it also hurts returns

The sharp market correction over the past few months may have created a dent in your portfolio of stocks and mutual funds. Some investors’ portfolios would surely have corrected more than others. And there could be many reasons for this. One important reason could be concentration. That is, holding stocks and funds concentrated on a particular sector that has shown weakness during the bear phase. However, while such concentrated portfolios increase risks, most investment experts also believe that excessive diversification also does not help in wealth creation in the long run. “Excessively diversified portfolio will never give extraordinary returns,” says G Pradeepkumar, CEO, Union AMC.

Amar Pandit, CFA, founder of HappynessFactory.in, also warns against over-diversification. “In terms of portfolio construction, over-diversification may lead to an overlap between similar kinds of strategies which doesn’t help in mitigating risk. Further, over-diversification would result in lower weight to each fund/stock in a portfolio. So, when the stock/fund moves in favour of the investor, the impact on t overall portfolio is low,” Pandit says.

How many stocks are adequate? While the risk-mitigation factor does not work in your favour beyond a point as you go on adding stocks, you may also find it difficult to manage a large holding.  Rajeev Thakkar, CIO, PPFAS Mutual Fund points out since the rate of risk mitigation becomes marginal beyond a point, one should limit the holding to around 15 stocks. “If you have just one stock in your portfolio the risk associated with it is 100 per cent. By just adding another stock, the risk falls to 50 per cent. However, if you keep adding more stocks the risk does not fall to that extent.  Hence, it is said, once you reach around 14-15 stocks, the bulk of the diversification is done. If an investor is keen to hold a higher number of stocks, it is better to invest in index funds which mirror the composition of a particular index,” Thakkar says.

Pradeepkumar says direct stock investing should be attempted only by informed investors, while the rest should take the mutual fund route. “Individuals investing directly in stocks should have the ability to track stocks and make informed decisions. Ordinary investors should ideally take exposure to stocks through mutual funds. However, if one is an informed investor with the ability to track development, 15-20 stocks in one’s portfolio are adequate,” he said.

Ideal number of mutual fund schemes: Equity mutual funds have stocks as their underlying investment and most schemes invest in a fair number of shares of companies.  Hence experts say that the number of funds one needs to hold in a portfolio is much lower than direct stocks.

“Mutual funds themselves have diversified portfolios.  Most investment needs should be met by having four-five funds. If you buy four-five funds it is quite possible even if there is an overlap of stocks among funds, you will be exposed to around 100 stocks or more,” says Pradeepkumar. Thakkar believes only two-three funds should suffice for a mutual fund investor.

Within the equity mutual fund universe, Pradeepkumar suggests investing in one multi-cap fund, one tax-saving fund (ELSS), a balanced advantage fund (where asset allocation between equity and debt happens dynamically, and market timing is taken care of by the fund itself) and a choice between a mid-cap and small-cap fund should be ideal.

Linking portfolio to goals and life stage: In general, your investments and selection of funds and stocks should depend on your financial goals, risk appetite and life stage. You should keep in mind your investment horizon and the time you need to achieve your goals. “One’s investments should be linked to financial goals. Someone who would need money to provide for child’s education 10 years later should invest the majority portion of the investments in equities. This is because equity needs time to perform as volatility decreases with an increase in investment horizon. A well-diversified portfolio across categories would not only help in mitigating risk but also work towards achieving your financial goals,” says Pandit.