What is diversification?
Diversification is a familiar term to most investors. In the most general sense, it can be summed up with this “not putting all of your eggs in one basket.”! This is generally done by investing in companies or mutual funds across diverse sectors, industries , styles and growth cycles.
However, not putting all your eggs in one basket is a good way to “spread” risk but its also a way to quietly murder returns! Each stock may reduce risk a bit – if at all – but ensure that returns are further out of reach if this diversification strategy is not planned well.
Rationale of Diversification?
Spreading investments across various sectors or industries with low correlation to each other can help control the risks that a portfolio with very few stocks would be vulnerable to. It is expected that since the correlation between the stocks within a portfolio is less, all stocks will not move up or down at the same time or at the same rate. So the overall portfolio is protected, as some stock may go up when others are going down. In case of long-term investment, this tends to ensure a more consistent portfolio performance.
However, there is a degree to which this can be done – attempts to diversify without paying attention to individual holdings or studying correlations between stocks can impair portfolio performance irreparably. For instance, if there are beneficiaries of domestic growth in your portfolio, do you have adequate international growth related stocks? Or do you have several multicap funds but all of them have similar holdings – does that make sense?
What is Over Diversification?
Over diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk.
When adding individual investments to a portfolio, each additional investment lowers risk but also lowers the expected return. Let’s look at two extremes; owning 1 stock or 1000 stocks. If you own just one stock your expected gain is very high but so is your risk. Your entire portfolio performance would ride on that one stock. It’s easy to understand the benefit of adding; going from one stock to two, or from five stocks to twenty stocks.
Each time an investment is added to the portfolio it lowers the risk of the portfolio, but by a smaller and smaller amount. At the same time each additional investment lowers the expected return. At some point you reach the number of investments where the marginal benefit of risk reduction is smaller than the decrease in expected gains. Assume you hold 40 stocks with equal weights in your portfolio. Then even a 50% jump in one stock will have a very minimal impact on the overall portfolio performance.
Empirically, it has been found that a portfolio of about 15-20 high conviction stocks/ funds offers optimum diversification.. On the other hand, if the portfolio has 40-50 stocks, then it’s a virtual mutual fund/ ETF! And some even go beyond 100 instruments which just simply doesn’t make sense!
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.
The risk of overdiversification is huge as 1) Excessive diversification might cause you To neglect what you do own and 2) Excessive diversification might cause you to dilute your best ideas as each position exerts a smaller influence on the portfolio.
Tips from a Legend!
Billionaire investor Warren Buffett recommended a mental trick to get around this. He told investors to imagine they had a punch card with only twenty slots on it. Each time they made an investment, they had to punch one of those slots. Once they ran out of slots, they could never buy another investment for the rest of their life. Buffett argued that this selectivity would cause a lot more intelligent behavior because people would learn about the things into which they are putting their money to work, leading to less risk-taking and better decisions.
Write to us at AdvisoryDesk@plindia.com if you wish us to see or review your portfolio and get our opinion.