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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Reading between the lines of portfolio diversification

Different investments do not perform well simultaneously

The fundamental logic behind diversification is based on the premise that assets are correlated to each other, either positively or negatively. After all, different types of investments do not perform well simultaneously. They react differently to various aspects such as global factors, domestic interest rates, corporate results, employment, monsoons and other factors in the economy.

This correlation between different asset classes comes efficiently into play in a diversified portfolio, which could result in a better performance that comes along with lower volatility and risk. This is the reason why it is imperative to decide on the right asset allocation for your investment portfolio and then sticking to it.

Diversification has different levels. On one level, there is diversification between broad asset classes such as equity, debt and cash (which would include liquid funds and short-term debt). The portfolios of some high net worth individuals are more complex and would also include real estate and other investments such as art, antiques and other such collectibles.

Within each asset class, there would be further diversification. An art collector might want to own not only a Picasso but also a Monet, a Tyeb Mehta and an M.F. Hussain. An equity investor would not only select stocks across various sectors and industries, but also between market capitalizations and geographical markets. So, she won’t concentrate her stock portfolio in just the developed markets, but will even look at emerging and frontier markets.

I have noticed that there is plenty of ammunition in the argument for diversification and there is no arguing against its logic. Yet, little is said about the dangers of over-diversification.

I have come across fund portfolios of numerous investors wherein the number of funds is as high as 15 or even more. Having so many funds is just not necessary as it doesn’t serve much purpose. One needs to diversify, but intelligently. A smartly diversified portfolio that consists of 4-6 funds can deliver a better performance than one that is packed with funds of similar mandates.

Similarly, I have also seen the stock portfolios of individuals wherein they sometimes hold 50-odd stocks. Again, this doesn’t really help. Investors should refrain from needlessly packing their portfolio—it has to be quality over quantity.

Once you own a desirable number of stocks, you have eliminated all the unsystematic risk. When you have reached this point, there is no need to own any more stocks if the purpose is to diversify your risk of concentration, that is, the unique risks associated with any one stock.

So what should be the desirable number of holdings? The exact number of stocks in your portfolio should depend on the amount of capital that you have.

A general rule is that a single stock should not corner more than 10% of your stock portfolio. So unless you are managing gigantic sums of money, restrict the total number of your holdings.

The number would also depend on whether you are hands-on in tracking your investments. Will you be able to keep track of these many securities? Ditto in the case of too many funds.

I believe that investing in something you do not fully understand can be even more detrimental to your investment portfolio than holding an inadequately diversified portfolio.

I am a firm advocate of investors holding on to a diversified portfolio. However, I would strongly caution against going overboard. Diversify, but diversify smartly and according to your situation.

There is no magic combination or rule of thumb. The actual level of diversification will depend, after all, on the individual’s level of income, number of dependants and age. What is also crucial is risk capacity and risk tolerance—yes, the two are different. But more of that another time.

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