Diversification of portfolio has off-late caught the attention of almost every investor these days. This buzzword is on every investor’s mouth and the next best suggestion once you start investing. Portfolio diversification is a technique that allows you to spread your investments across different types and categories of investment instruments that cushions against the inherent risk these investments carry. For ex: SBI Bluechip Mutual Fund and Axis Long Term Equity Fund.
Yet, there are some loopholes to portfolio diversification as well. Too much of everything is harmful, be it food, love or portfolio diversification. In the league of diversifying, people generally tend to over diversify their portfolio essentially taking away the purpose of doing so. This will also adversely affect the returns you gain over your investments as there would be a lot of disproportion in your securities. To have a better understanding of this concept, here are few insights;
What is Portfolio Diversification?
The act of reducing overall risk in a portfolio by spreading the investment evenly across different sectors and industries is called portfolio diversification. This prevents an investor to invest all his funds in one type of stock which can later prove to be highly risky.
If the investments are made across different industries that are not correlated with each other then there are very low chances of getting affected by market corrections and volatility.
What is Portfolio Over-Diversification?
In the process of diversifying a portfolio, investors do not know where to stop or how many are too many? A typical case of over-diversification is when the loss on returns grows higher than benefits on risks due to an excessive number of stocks in your portfolio.
With every stock added in your portfolio, the risk is lowered and alongside the expected returns also face a jitter. It is very important that you know when and where to stop while diversifying your portfolio.
Optimum Portfolio Diversification
Although, with different investor classes and types of investments around it is very hard to define a single number which can be called the optimum diversification number. The experts in the industry believe that having around 15 to 30 different stocks in your portfolio can be really helpful in achieving the right level of expected returns and reduced systematic risk. These stocks must be spread across different industries and sectors so as to avoid any correlation between them.
Also, with this adequate number of funds, management will be very easy and this will keep you away from unnecessarily managing heap of funds that are under-performers. Hence, optimum portfolio diversification refers to managing a particular range of investments which helps reduce the systematic and unsystematic risk and also keeps up with the expected returns being high performers in the market.
Since the market moves in cyclic phases, there is always hope for another sector to be performing high while one is in the lower cycle. With a mix of industries and sectors, you can manage the risk by reducing it to a minimum possible (of course, risk can never be eliminated from the portfolio completely).
Does diversification ensure a near 100% risk mitigation?
No, this is not true. No technique or formula in this world can ensure a near 100 percent risk mitigation from your investment portfolio. Mutual funds and other money market securities come with an inherent risk which can only be reduced to a certain extent beyond which no diversification or stock addition can help. According to modern portfolio theory, about up to 20 stocks are beneficial in reducing the associated risk in the portfolio depending upon the industry chosen. Beyond 25 to 30, there is a slight reduction in the risk which gets nullified over the increased loss in benefits and returns due to over-stuffing of the portfolio.
Mutual Funds and Portfolio Diversification
When it comes to mutual funds, balanced funds are the best category of funds if you want to go for pre-diversified funds. balanced funds are spread across around 100 different sectors of the market and provide near optimum diversification to the investor.
There is a difference between over-all diversification and being diversified within the same sector. For example, you might be owning a fund that is invested across various companies within the same sector as within the automobile sector. If unfortunately, a shock wave comes, your fund is bound to bleed red due to being spread within the same industry.
Portfolio diversification is best achieved by manual electing the funds of taking the help of a financial advisor. A tailor-made solution will take care of your risk and return profile meanwhile providing with the best combination of funds optimizing diversification.
Portfolio diversification is essential to your investments but you should know where to stop. Over-diversification can prove to be causing more harm than the benefit it is supposed to do. Not every fund you bring in house is for the good; if reduced risk leads to reduced returns, it is time that you rethink your decision.