Mumbai: We all know that too much of anything good is also bad. The same holds true with portfolio diversification too. Depending on your age, investment objective, financial profile, and risk appetite, you must diversify your investment across different asset classes such as equity, debt, real estate, gold and so on.
This diversification helps you to maximize your returns given a certain risk profile and protects the total investment corpus from any downside that may happen in a particular asset class.
Suppose you invested all your money in equity, any downturn in the markets will mean huge losses for you. Alternatively if all your money were invested in bank FD (fixed deposit), you will lose the opportunity to improve your returns, if a part of this was prudently invested in equity.
Or suppose you invested your equity corpus in just one-two stocks, then the risk is high. You must add more stocks to diversify the portfolio and reduce the risk. But if you take this diversification strategy too far, you could end-up being a loser.
Investing your money across too many stocks or too many instruments makes the portfolio unmanageable.
Assuming that you have Rs 10 lakhs and as per your risk profile, you are willing to invest Rs.4 lakhs in equity. And you use this Rs 4 lakhs to build a portfolio of 30 stocks. You will now have to research and keep track of 30 companies.
Further, you will also have to study newer stocks, which show good future potential. Then you would have to sell a few stocks from your existing portfolio, which show the least potential and buy the new ones.
It is but natural that all this eats up too much of one’s time and effort. This may not be commensurate with the improvement in the returns one can expect. Secondly, there is good chance of missing out on opportunities to sell and/or to buy at the right time.
Thirdly, too much diversification results are average returns. By investing in fewer but best of the best stocks, one improves the chances of earning better overall returns. One need not invest in average stocks just for the sake of diversification.
Further, an over-diversified portfolio becomes less flexible, which means your response time to any market changes becomes slower. Thus, from the point of view of efficient portfolio management, flexibility and better returns, it is important to have right amount of diversification. It is like, for a given height there is right weight. Both, being too thin or too fat, are bad.
It is difficult to get proper diversification if the corpus is too small. But assuming one had a fairly large equity corpus, the modern portfolio theory suggest that having about 17-20 stocks, adequately spread across various sectors and market-caps, should be more or less sufficient. Beyond that one will only add to the efforts without getting any significant diversification benefits; and maybe even compromise on returns.
One of the secrets of success of Warren Buffet, the legendary investor and world’s second richest man, is to buy fewer stocks but those, which you understand, the best. There is no point in adding more and more stocks to your portfolio with only half-baked knowledge about them.
Therefore, even when you choose a diversified equity mutual fund, it is important to look at its’ portfolio mix – how many stocks it invests in on an average, how many industries does it diversify into, is it overweight on just a few industries/stocks etc. This will enable you to select a rightly diversified fund.
One must, however, remember that diversification only reduces the company risk. The market risk still remains. So if the market crashes, even the best of the diversified portfolio will lose money, more or less equivalent to the market fall.
Similarly, when diversifying on the debt side, ensure that the investment is not made in too many instruments that it becomes difficult to keep track. Many times the FDs/bonds may have matured but we realize it only too late, thereby losing on some interest we could have earned in the interim.
Secondly, too many of small investment would mean very small interest inflows, which will be difficult to re-deploy and hence remain idle till a sizeable amount is accumulated.
A well-balanced portfolio, which matches your risk profile and investment objective, is the key to financial success. Take out some time and make efforts to build a suitable financial, before you start investing. A good plan is like a good map, you will reach your destination conveniently and chances of getting lost are very less.
The author, Sanjay Matai, is an investment advisor.
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