Learn With ETMarkets: How over diversification affects your portfolio?

We all must have attended at least one wedding that served some delicious food. And you won’t deny that we all have the urge to taste everything on the menu, so we pile every dish onto our plates even if there is no place to add more.

This is the perfect example of over-diversification, which we often do to our portfolios. We end up piling too many investment options in our portfolio by investing small chunks of capital in multiple investment options like direct equity, a few types of mutual funds and ETFs.

At the end of the day, we think that our portfolio is perfectly diversified. But, in reality, our portfolio has been overcrowded because of adding too much to it.

How over-diversification affects your portfolio?
Let’s understand the situation with an example. Suppose Mr X has already invested in a few mid-cap, small-cap, and large-cap stocks from different sectors in his portfolio.

One fine day, he learns that his friend has started investing in several mutual fund SIPs. So, he also decides to invest in mid-cap, small-cap, and large-cap mutual funds.

Now the situation is such that Mr X had already invested in a few large-cap stocks like Reliance Industries, TCS, HDFC Bank, etc., which are a part of his large-cap mutual fund. This unnecessary diversification has increased Mr X’s exposure in a few stocks.

In this case, if a few companies perform well, the overall returns will be low as Mr X has too many stocks and an imbalanced exposure to a few stocks in his portfolio.

Moreover, adding too many stocks can be tedious as you won’t be able to keep a check on each company’s quarterly reports, annual reports, balance sheets, and other financials.

So, how much is too much? And how to attain the perfect balance in your portfolio?

Let’s find out.

What is appropriate portfolio diversification?
In the book ‘The Intelligent Investor’, Benjamin Graham suggests investors build a perfectly diversified portfolio by adding not more than 10 to 30 quality stocks across sectors with low correlation.

According to his philosophy, we reduce the chances of losing when we invest in stocks across different sectors with low correlation.

It is recommended that apart from equities, you add safe investments to your portfolio, like gold, real estate, bonds, and fixed deposits.

If you wish to invest in gold, you need not make jewellery. You can buy gold ETFs, digital gold, Sovereign Gold Bonds (SGB) or a gold mutual fund. Similarly, investing in real estate has become much easier and cheaper with Real Estate Investment Trusts (REITs).

Now, you just have one challenge to overcome. This challenge is picking quality stocks. Don’t worry; you can simply opt for ready-to-invest portfolios, one of the best ways to invest in the stock market.

So, the next time you think about investing in the stock market, consider looking at ready-to-invest portfolios too.

*Stocks mentioned in the article are for informational purposes. This is not investment advice".

(The author is Head of Research, Teji Mandi)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)