Diversification is good, but too much of it can be harmful for your portfolio
As a rule of thumb, four to seven funds are enough for your portfolio to be adequately diversified
Shalabh Agarwal, 28, began investing in mutual funds when he started working in the merchant navy in 2013. “At the time, there was suddenly a lot of information about mutual funds. I read a lot about SIPs (systematic investment plans), STPs (systematic transfer plans) and fund performance and decided to start investing," he said. Like many first-time investors, Agarwal took the DIY route and started investing about ₹5,000 each in 10 mutual funds across categories. “I did my own reading and research to find the right funds. I had two large-caps, two mid-caps, two small-caps, one index fund, a couple of sectoral funds, and all of them were rated four or five stars," he said.
In a year or so, Agarwal found himself struggling with an over-diversified portfolio. “I was investing close to ₹50,000 a month, and I expected substantial returns. But I realized that I was not getting any returns as the gains and losses cancelled each other out," he said.
While most planners and experts recommend diversifying your portfolio, going overboard with it is not a good idea. “Over-diversification leads to a compromise on the returns since it can take away your ability to invest a substantial amount in good schemes or instruments. Also, it leads to profits from high-performing schemes getting compromised by losses from low-performing ones," said Shilpi Johri, founder of Arthashastra Consulting, a financial planning firm.
So how much is too much when it comes to diversification and how can you dial back your investments, if need be?
Problem of plenty
Agarwal is no exception. Many investors find themselves holding too many mutual funds, having been advised by distributors or friends and relatives.
“Many people have numerous funds in the portfolio. A few have as many at 40, but 20-30 is not uncommon. This is partly due to the historical method of selling mutual funds, as the distribution agent was incentivised to push new funds," said Sanjiv Singhal, founder and COO, Scripbox, a mutual fund startup company.
While diversification is a wise move since it lowers your exposure to risk, like all good things, too much of it can do more harm than good. “Diversification delivers better than average returns and prevents the investor from going horribly wrong. But over-diversification is not good for the portfolio," said Raj Khosla, founder and managing director, MyMoneyMantra, a financial services firm.
Ramji Porwal, a 34-year-old internal consultant in an investment bank, started investing with the idea that diversification reduces the chances of making a loss. “Everyone suggested different stocks and funds to invest in and I saw magazines and newspapers list funds that were doing well, and I wanted a piece of the pie," he said. While he was on the right track, he kept adding to his portfolio, ending up with an unmanageable portfolio of more than 25 funds.
Having too many funds impacts the overall portfolio through lack of focus and, therefore, even good choices don’t boost returns, said Singhal. While you might not be making losses with an over-diversified portfolio, your returns can take a hit. “A portfolio with a large number of funds will be difficult to monitor. As a result, one may continue to hold underperforming schemes. This could hit returns in the long run," said Khosla.
Also, if you compare the portfolios of some leading funds, you will find a lot of duplication. “Buying too many funds will only duplicate the holdings and not lead to any meaningful diversification for the investor," said Khosla.
Porwal soon realized this about his portfolio. “I saw that funds in the same category rise and fall together, so having multiple funds in the same category doesn’t help much," he said.
Eutting to size
If your returns are suffering or you’re simply overwhelmed by the task of calculating your tax liability and managing your funds because of over-diversification, it’s time to downsize.
“If your current portfolio has too many funds, you can start by weeding out the very small holdings, that is, any fund where your overall allocation is less than 1-2%. Then focus on the poorly performing funds," said Singhal.
Porwal did just that. “I singled out a few plans according to my needs, and slowly started getting rid of the rest," he said. He was careful about exit loads and tax liability, and it took him two years to downsize his portfolio from 25 to just seven funds.
Agarwal, too, has downsized his portfolio after doing his own research and consulting a financial adviser. “If you want to invest ₹80,000 to ₹1 lakh a month, you should pick three or four solid funds and invest large sums like ₹20,000 in each. After you continue with the SIPs for a year, you can easily see which of your funds is doing well and which is not and make changes if needed," he said.
How much is enough?
While the number of funds you should hold is subjective, there is a basic cut off for most people. As a rule of thumb, four to seven funds are enough for your portfolio to be adequately diversified. “While it depends on the size of the portfolio, ideally six to seven funds are sufficient," said Johri.
Distribute your allocation among large-cap, mid-cap, small-cap and multi-cap funds according to your risk appetite and goals.
“One should have an index fund as the core of the portfolio with 50% of the corpus value. This should be followed by 1-2 mid-cap funds with 20% of corpus value, and 1-2 multi-cap funds with 20% of corpus value. A small-cap fund with 10% of corpus value can be the return booster," said Khosla.
Keep in mind that this allocation will differ according to your age, life stage, financial goals, and your risk appetite. For instance, large-caps will be ideal if you want to play it safe, while mid-caps give you the opportunity to invest in a company that may become an overnight success, and small-caps can be capitalised by those with a long investment horizon and medium- to high-risk appetite.
There is no one way to build the ideal portfolio. You have to be prepared to do your research and find out what works for you. If you’re a beginner, it might be wise to consult a financial adviser to choose the right funds. But no matter what funds you choose, remember to keep your portfolio small and manageable.
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