For serious equity investors, the concept of Diversification is neither new nor unknown.
It’s a word that we long-term investors have heard countless times and which, also finds its way into the vocabulary whenever portfolio management is discussed. But unfortunately, excessive diversification is rarely discussed.
Yes, we definitely agree with the premise of diversification and why it makes sense to not put all eggs in one basket. The problem arises when this concept of diversification is taken a little too far that it fails to serve its very purpose and if stretched too far, can even hurt portfolio returns. Hence, a proper understanding of the intricacies involved is recommended before an investor gets started with portfolio allocation.
What Is Diversification?
It is a prudent strategy to ensure proper portfolio and risk management. Diversification in a stock portfolio is an attempt to lessen the inherent risk of holding only one or one kind of stocks. This generally done by investing in companies across diverse sectors, industries and even growth cycles.
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.
Why this happens is obvious. 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.
Diversification Or Di(WORSE)ification
The basic premise of diversification is to reduce the risk. But it is very important to understand and remember that the no matter how diversified the stock portfolio is, the risk can never be eliminated though it can be reduced to a certain extent.
So just adding more and more stocks in the portfolio will not eliminate the risk.
Each time a new stock is added to the portfolio, it lowers the risk of the portfolio but by smaller and smaller amount each time. That’s not all. If the stocks are added by order of (at least theoretical) potential returns, then each additional stock lowers the expected return too!
But this doesn’t mean that we can or should hold a 1-stock portfolio. The risk is just too high and can have disastrous consequences if the investment thesis is proven incorrect eventually.
Once you begin adding stocks to a portfolio, there will come a point where the decrease in expected gains will surpass the marginal benefit of risk reduction.
When there are too many stocks in the portfolio in the name of diversification, then it simply means that the portfolio does not own the highest conviction and best quality stocks.
How Much Diversification Is Too Much?
The adequate level of diversification is debatable.
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.
Can Over Diversification lead to Return Reduction?
Yes. It’s certainly possible.
The more stocks you put into the portfolio, the less concentrated your portfolio will be in the best opportunities. Quality suffers when you own inferior long term investments along with good investments.
In fact, since you will be introducing more stocks in the portfolio, excessive diversification can force you to lower your investment standards as the last stock you introduce in the portfolio will not be as high-potential as the first one.
As each position will exert a smaller influence on the portfolio, you will be forced to dilute your best ideas in name of (over)diversification.
For example - 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. Same will be the case with multibagger stocks that will be unable to push up the portfolio performance significantly.
Excessive diversification is pointless and can potentially damage portfolio returns if not handled well.
When you invest in direct stocks, the idea is to do well and aim for higher than average (or market) returns. But for a long term investment to make a sizeable impact on your overall returns, it should form a reasonable part of your portfolio.
Therefore, a portfolio should no doubt be diversified. But not so much that none of the stocks has a reasonable say in overall portfolio returns.
If a portfolio is not constructed judiciously and is over-diversified, it will only generate average returns or in some cases, lower-than-average returns. It is worth saying that one should be careful about diversifying the portfolio. And if one is unable to decide the stocks and their weights in the portfolio, it’s best to take help of competent and trustworthy investment advisors who can create an optimally diversified portfolio of fundamentally strong stocks.