Sunday, May 22, 2011

The problem with (too much) Diversification

Diversification (n) - The act of introducing variety (especially in investments or in the variety of goods and services offered). Diversification is something all financial planners suggest sticking to the adage – ‘Not putting all the eggs in one basket’. Though this strategy makes a lot of sense, I have rarely seen people follow this strategy in its right sense. People other over-diversify or diversify within a sector (like buying a lot of funds all which invest in real estate stocks), both of which defeats the purpose of the strategy of diversifying. The real purpose of diversification is to minimize risk by spreading your investments across different stocks or assets, so that in case one of them does badly, the performance of the other assets or stocks would ensure that the average performance of your investments are good.
I was prompted to write this article when a friend of mine recently showed me his portfolio of funds. He owned a total of 23 funds! And his reason for investing in so many funds was because he thought that was ‘diversifying’ and by doing so he would get good returns at a lower risk! The result
– He had so many funds – some which performed well and some which didn’t that, in the end he was getting a very poor return from his ‘diversified’ portfolio!
First of all, I would like to reiterate that, the objective of diversification is to reduce risk, by spreading your risk across different sectors of stocks and not to increase returns! Secondly if you start buying different diversified funds, you end up spreading your investments so thin that you may not end making any meaningful gains. Most diversified mutual funds already diversify your investments across companies spanning across sectors. By buying several diversified funds you are overdoing the concept of diversification. And if you are that risk averse, you can look at investments that yield a fixed return like Bank FDs, Provident Fund account or Government bonds like the National Savings Certificate.
Investment gurus like Warren Buffet do not encourage much diversification because he believes in ‘Putting his eggs in one basket and watching that basket carefully’. It just means that when he invests in a stock, he would invest in it only if he is dead sure about the growth prospects of that company or in his words ‘buying a great business at a fine price’. For those who want to get the benefit of good investment returns from equity but at the same time are slightly risk averse, I would suggest that you invest in a Large Cap Diversified Fund. There are several good large cap diversified funds and these are considered to be amongst the safer equity mutual funds. Do not invest in any particular sectoral fund (like infrastructure fund, telecom fund, FMCG fund, IT fund etc.), unless you are sure that sector is poised for remarkable growth. Investing in sectoral funds from different fund houses is NOT diversification (my friend had 5 Infrastructure funds from five different fund houses). You are just concentrating your investment in a sector and most sectoral funds would have a lot of stocks in common across different fund houses.
I would suggest that you hold not more than 2 – 3 mutual funds (after doing some amount of research on good funds) and if you want to diversify, buy diversified mutual funds not a plethora of mutual funds.

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