“Diversify your portfolio” has become the buzzword recently.
Every fund manager will suggest you do this. Agreed, a portfolio must be diversified to reduce the inherent risk of holding only one or one kind of stock. But how much?
Sometimes, investors end up overdoing it, resulting in more pain than gain.
Over-diversification has lately come up as a common mistake that reduces investment returns disproportionately to the benefits received.
This idea came up because, previously, many investors were putting all eggs in one basket, and the result was either a big profit or a big loss. But just like under-diversifying is a problem, over-diversification is a problem too.
Let us dig in deeper to find out how one should manage his/her portfolio for maximum returns and peace of mind.
Understanding Diversification
In a stock portfolio, when an investor tries to reduce the risk exposure by investing in various companies across different sectors and industries, it is termed Diversification.
According to probability theory, by spreading your investments across various sectors or industries with minimal or no correlation to each other, there are reduced chances of price volatility.
What is Over Diversification
Overdiversification happens when the number of investments in a portfolio exceeds a point where the marginal loss of expected return is higher than the marginal benefit of reduced risk.
In your existing portfolio, every time a new script is added, it lowers the risk of the portfolio to a very small extent. But at the same time, each additional investment lowers the expected return.
Let us understand it with an example, if you own 500 different stocks, you have reduced the unsystematic risk, but at this stage, your portfolio does not have a good number of high-performance stocks.
On top of that, you will have to research all 500 stocks for suitability in your portfolio. Surely, there will be a significant difference in the performance of the top and bottom ones in the list.
Chances are, owning 500 stocks, you will end up being in a no-profit no-loss situation, but then what’s the point of investing?
Optimal or Proper Diversification
Most experts believe a portfolio diversification strategy having between 15 and 30 different assets is optimal to diversify away from the unsystematic risk.
Proper diversification would require these assets to be spread among several different sectors and industries.
The point is you might be better off owning the 30 best stocks for your portfolio (among a variety of industries) than owning 30 of the best stocks plus 970 non-optimal stocks that pull down your portfolio performance.
In other words, the increased benefits from owning 970 additional stocks would be small compared to the expected loss of return.
Most investors have experienced the poor results of over-diversification. This is because many institutional vehicles (i.e. diversified mutual funds, pension funds, equity index funds, ETFs, etc.) are over diversified and therefore lack the ability to concentrate on quality instead of quantity.
What is Optimum Portfolio Diversification?
The optimum portfolio diversification is to own a number of individual investments large enough to nearly eliminate unsystematic risk but small enough to concentrate on the best opportunities.
This is because different industries and sectors don’t move up and down at the same time or at the same rate.
If you mix things up in your portfolio, you’re less likely to experience major drops because as some sectors encounter tough times, others may be thriving. This provides for a more consistent overall portfolio performance.
That said, it’s important to remember that no matter how diversified your portfolio is, your risk can never be eliminated.
You can reduce the 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.
Can We Diversify Unsystematic Risk?
The generally accepted way to measure risk is by looking at volatility levels.
That is, the more sharply a stock or portfolio moves within a period of time, the riskier that asset is. A statistical concept called standard deviation is used to measure volatility.
According to modern portfolio theory, you’d come very close to achieving optimal diversity after adding about the twentieth stock to your portfolio.
In Edwin J. Elton and Martin J. Gruber’s book “Modern Portfolio Theory and Investment Analysis,” they concluded that the average standard deviation (risk) of a single stock portfolio was 49.2 percent while increasing the number of stocks in the average well-balanced portfolio could reduce the portfolio’s standard deviation to a maximum of 19.2 percent (this number represents market risk).
However, they also found that with a portfolio of 20 stocks, the risk was reduced to about 20 percent.
Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio’s risk by about 0.8 percent, while the first 20 stocks reduced the portfolio’s risk by 29.2 percent.
Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn’t be farther from the truth.
There is strong evidence that you can only reduce your risk to a certain point beyond which there is no further benefit from diversification.
True Diversification
The study mentioned above wasn’t suggest that buying any 20 stocks equates with optimum diversification.
Note from our original explanation of diversification that you need to buy stocks that are different from each other, whether by company size, industry, sector, country, etc.
Financially speaking, this means you are buying stocks that are uncorrelated – stocks that move in different directions during different times.
Here, we are only talking about diversification within your stock portfolio.
A person’s overall portfolio should also diversify among different asset classes — meaning allocating a certain percentage to bonds, commodities, real estate, alternative assets, and so on.
Coming to your specific situation, with a 25-year time frame, you can afford to have an all-equity portfolio to start with.
So, the only diversification elements that should concern you would be market and fund management diversifications. You can achieve them both easily with a good five-fund portfolio.
You could have one large-cap fund (30%), two diversified funds (20% each), and two small- and mid-cap funds (15% each). You can choose these funds from different fund houses to achieve diversification in fund management styles.
How Do Mutual Funds Affect Diversification?
Owning a mutual fund that invests in 100 companies doesn’t necessarily mean that you are at optimum diversification either.
Many mutual funds are sector-specific, so owning a telecom or healthcare mutual fund means you are diversified within that industry.
Although, because of the high correlation between movements in stocks prices within an industry, you are not diversified to the extent you could be by investing across various industries and sectors.
Balanced funds offer better risk protection than sector-specific mutual fund because they own 100 or more stocks across the entire market.
Many mutual fund holders also suffer from being over-diversified.
Some funds, especially the larger ones, have so many assets (i.e. cash to invest) that they have to hold literally hundreds of stocks, and consequently, so do you.
In some cases, this makes it nearly impossible for the fund to outperform indexes — the whole reason you invested in the fund and are paying the fund manager a management fee.
Also, Read How to Monitor Your Stock Portfolio?
The Bottom Line
Diversifying your mutual fund portfolio by investing in multiple funds is a good thing, but only to a certain extent.
Each new fund that you bring into your portfolio does reduce the risk a bit, but it also has two potential side effects.
Over diversifying your portfolio reduces the magnitude of gains you could have from the good funds in your portfolio (since to invest in many funds, you’ll be investing less in each fund).
To put it another way, with wide diversification, you will not lose much, but you do not stand to gain much, either. The other negative is that a large portfolio is tougher to maintain, monitor, and manage over time.
Mutual fund portfolios tend to be long-term portfolios, and as years go by, one needs to review the portfolio periodically to keep it in shape.
Doing so is more difficult for a large portfolio than for a smaller and simpler portfolio.
According to Warren Buffett, “Wide diversification is only required when investors do not understand what they are doing.”
In other words, if you diversify too much, you might not lose much, but you won’t gain much either!
Happy Investing!
