How to Avoid Portfolio Over-Diversification?
- 5 min read
As an investor, you must have heard about the term portfolio diversification to ensure proper returns on your investments. When you diversify your investment, you do not solely focus on a particular stock from a specific company but invest in multiple securities.
It helps you mitigate your investment risks, as during a market downturn, a particular investment might be at risk, but other investment assets protect you from this negative impact.
However, over-diversification can lead to a situation where marginal losses may surpass your marginal benefits. Read this blog and learn how to avoid portfolio over-diversification in detail.
What is Portfolio Diversification?
As an investor, when you are trading in securities, there is always a risk of running into losses due to market downturns, company performance, etc.
To avoid losses, portfolio diversification works as a key investment strategy that allows you to invest in multiple securities across different asset classes. The objective of diversification is to minimise the risks and increase the chances of gaining a consistent return over time.
For example, if you have stocks of Indian companies in your portfolio, you can diversify it by investing in various investment options, such as equities, bonds, mutual funds and more. These options will safeguard your portfolio and minimise your investment losses.
What Does Over-Diversification Mean?
You might arrive at an over-diversification situation in your investment journey where the amount of investment in your portfolio surpasses a point where the expected losses outweigh your marginal benefits. In such a scenario, adding a new security or asset may reduce overall risk, but it takes away your expected returns.
For example, suppose you own 400 different company stocks, and it may seem good for diversification, but managing this amount of securities is daunting. Moreover, there can be disparity in performance between the top and bottom-performing stocks, resulting in losses.
Thus, holding such a wide variety of stocks often results in a no-profit scenario, and striking the right balance in portfolio diversification becomes important. Over-diversification can weaken your portfolio, with a lack of potential for an optimised return on investment.
How to Avoid Portfolio Over-Diversification?
Now that you know the difference between diversification and over-diversification, you must be curious about how to avoid portfolio over-diversification in real-time. Take note of the following advice and steer clear of over-diversification:
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Setting Financial or Investment Goals Clearly
Before delving into investment, you must have a clear idea about your financial or investment goals. Furthermore, assess your risk appetite and note down your risk tolerance limit, returns you expect from the market and your time horizon. Such clarified objectives will help in making correct investment decisions and steer clear of loss-making diversification.
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Do Proper Research
While investing, you must avoid the practice of investing in securities straightaway, without proper research. Instead, take your time and conduct in-depth research about the asset you want to add and understand its return potential. It helps in adding securities to your portfolio that can increase its value and align with your investment objectives.
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Limit Your Holdings
Although diversification might tell you to invest in securities from different asset classes, you must maintain a limit. You can do this by adding about 15 or 20 high-quality securities with a good return potential.
Tips to Avoid Portfolio Over-Diversification
In addition to the practical actions, take note of some extra tips to avoid portfolio over-diversification better:
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Regular Optimisation
To keep your portfolio safe from over-diversification, you should optimise it regularly or at least periodically. You should assess the ongoing performance of your investment assets and locate and eliminate underperforming ones to optimise your portfolio.
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Look for Different Fund Categories
You should also diversify your investments into different fund categories like equity, hybrid or debt funds, instead of focusing on the same category. Equity funds allow growth, while debt funds bring stability, and hybrid funds strike a balance between wealth generation and stability.
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Avoid Higher Costs
Your over-diversified portfolio is prone to attract higher costs. Therefore, weigh the cost of diversification optimally against potential benefits. You can opt for a low-cost option that allows you to diversify your portfolio without incurring higher costs.
Conclusion
Learning how to avoid portfolio over-diversification is crucial for you, as it might harm the potential of returns from investments. You must conduct in-depth research on securities for their return potential and set a limit to keep your portfolio manageable.
FAQ’s
1. How can I identify if my portfolio is over-diversified?
When you do not set a proper plan for diversification, it might result in over-diversification. For example, when you invest in overlapping securities, which means holding similar assets that provide no adequate diversification.
2. What is the optimal number of investments to have in a portfolio?
Depending on your financial goals, you must choose high-quality assets and keep them under a limit. Adding 15-20 assets allows for easy portfolio management.
3. Is sector or industry over-diversification a problem?
Yes, sector or industry-over-diversification is a problem in portfolio diversification. For example, if you hold multiple ETFs or index funds of the same sector, you might think you are getting broader market exposure. However, this approach duplicates the investments.
4. What role does rebalancing play in preventing over-diversification?
Portfolio rebalancing helps you to avoid over-diversification. With rebalancing, you can determine and eliminate underperforming assets and add assets with return potential.
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Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
