Understanding the Dangers of Wide Diversification
While diversification is recommended to reduce exposure to risk, many investors take the concept too far. The fact is that the addition of a fund or stock to a portfolio does not keep on reducing the inherent risk. It has been proven that diversification helps reducing the overall risk of the portfolio upto a certain point, after which it can prove to be unfavourable rather than beneficial. Let us see how.
Modern Portfolio Theory and Over Diversification
According to the Modern Portfolio Theory, founded by Edwin J. Elton and Martin J. Gruber, your portfolio would achieve optimal diversification after adding approximately the 20th stock. They concluded that a portfolio with just one stock has a risk (or standard deviation) of 49.2% (little less than half). They discovered that by the time you added the 20th stock to the portfolio, the risk was reduced to 20%. However, adding additional stocks anywhere from 21 to 1,000 only reduced the risk by a mere 0.8%. This was negligible when compared to the reduced risk of the portfolio from the first 20 stocks by 29.2% (49.2%-20%).
That is to say that if you diversify too widely, you may not lose too much, but you won’t gain much either.
When looking at mutual funds, one common mistake many of us do is hold a number of mutual fund investments having the same investment objective or stock picks. This would mean that the majority of the portfolio will have the same nature of risk and perform almost similarly at a given period of time. This not only defeats the purpose of diversification, but you also end up paying more for creating duplication in your portfolio. It works best when investments are spread out, albeit not too thinly or over diversified, across options that behave differently under the same market conditions. In other words, they have a low correlation to each other.
For example, having 4-5 equity diversified mutual funds (large-cap, mid-cap, small-cap and multi-cap) investing across sectors, companies and geographies gives you a better diversified portfolio than investing in a sector specific mutual fund having 90 stocks of different companies from the same sector.
Dangers of Wide Diversification
The main disadvantage of wide or over diversification is that it erodes the performance of your portfolio. If your capital is spread too thin among investments, then any high performance of one asset or fund will have a marginal impact on other investments. This leads to an average or below average overall performance. Further an over diversified portfolio will have a higher tax liability and transaction costs that will eat into your returns.
Wide diversification also leads to the problem of plenty. It is often highly cumbersome to keep a track of too many investments. In such a case, there is a probability that you would not be able to keep an eye on the investment objectives or if the portfolio needs rebalancing, leading to potential losses.
What to do if you have an Over Diversified Portfolio?
If you have inadvertently created an over diversified portfolio, you can easily prune it back to shape by making sure that you get rid of similar investments after comparing investment objectives and transaction costs. At the same time, make sure that you don’t lose or sell out a well performing asset, stock or a fund, in a hurry to book profits and reduce the size of your portfolio.
In conclusion, one can definitely say that diversification is like sugar. It will boost the flavour of your desserts when used in small quantities, but is harmful when consumed in excess.
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