Hey, how much do I need to invest?
This turns out to be the most common question.
Let me start with an adage by the famous investor Warren Buffett. In one interview, he said that ‘Wide diversification is only required when investors do not understand what they are doing.’
How true is this! In the parlance of investing, especially for first-time or novice investors, believe that equities are risky. However, risk comes from not knowing what we are doing.
And when an investor is not aware of where to invest, why to invest, when to invest and how to invest, the result is often over-diversification or under diversification. This happens when an investor is not informed about their goals, risk appetite or right methodology; they tend to invest randomly.
Let’s have a look at what is over-diversification and under diversification.
- Investing in many asset classes
- In the case of equities, investing in too many stocks from various sectors in the name of diversification
- The decrease in expected gains will surpass the marginal benefit of risk reduction
- Increased paperwork and monitoring task
- Exposure to only a single asset class
- In the case of equities, investing in a single sector or theme
- High risk is heavily dependent on a single asset class or sector
Over or under diversification are one of the most common financial diseases that investors face.
Recently, when I was talking to one investor, I asked him a simple question, ‘Are you an existing equity investor?’
He worriedly replied, ‘I have 80 stocks in my portfolio along with investments in various Equity Linked Savings Scheme (ELSS) and debt funds. Now, I don’t have any clue about what to do with these stocks.’
Taking the above example only, 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. The same will be the case with multibagger stocks that will be unable to push up the portfolio performance significantly.
Coming to under diversification, say you have invested only in XYZ sector or is invested in just 2-4 stocks. And, if the sector recently witnessed a few regulation changes that led to the fall in the prices of all the companies in that sector. Even your stock saw 40% fall. Isn’t that a huge risk? Or if one of the 2-4 stocks experiences some turbulence, it is only for you to guess the impact it would have on your overall savings, investment & your future plans.
We’ll never be able to predict the market movement, it’s important to build a well-diversified (and not over or under) portfolio.
Alexa, Tell Me The Meaning Of Optimal Diversification
Holding just 5-8 stocks is best for professional and knowledgeable investors who have been investing for many years in the Indian stock market. It’s a high conviction, high risk and high reward approach that is most suitable for smart investors.
On the other hand, if the portfolio has 40-50 stocks, then it’s a virtual mutual fund. The returns would be similar to mutual fund returns.
The whole idea of investing in stocks directly is to do better than mutual funds. Isn't it?
Empirically, it has been found that a portfolio of about 15-20 stocks offers optimum diversification. Beyond this, it tends to become over-diversified.
But of course, there is no hard and fast rule about how many stocks can be called as optimally diversified or over-diversified.
A Sanity Check
It is crucial to be careful while investing. Understanding of one’s own financial goals plays a significant role in investing in the relevant asset class or determining the number of stocks.
Remember: Every goal requires a personalized approach i.e. a personalized portfolio. While the ideal number is 15-20 stocks, it’s advisable to meet the financial doctor to understand if you’re suffering from the disease of over or under diversification. Staying Calm & Seeing The Doctor Can Help You With The Right Prescription To Get Rid Of This Disease!