Though we've extolled the virtues of diversification often enough, its importance cannot be over-emphasised. The exercise helps mitigate the risk associated with individual investments by spreading these across several securities that bear little correlation to one another.
Instead of putting a large chunk of money in one asset and bearing a sizeable loss when its value plummets, it's better to spread the capital across various assets. If one of the these underperforms, the negative impact on the portfolio will be muted as the other holdings will, hopefully, do well. In case of stocks, you should invest in companies varying in size, industry and even geography.
But no matter how widely diversified a portfolio, the risk can never be eliminated entirely. So don't hoard investments blindly in the hope that you will tide over the market's uncertainties. At times, too much of a good thing can yield undesirable results; piling a large number of stocks and mutual funds may do more harm to your portfolio than good.
Says Vetri Subramaniam, head , equity funds, Religare Mutual Fund: "Diversification is a desirable goal for an investor. However, as you diversify, you not only reduce risk, but also the returns. So investors must keep this trade-off in mind." Here is how over-diversification can erode the performance of your portfolio.
Low impact of outperforming investments
If you have too many stocks in a portfolio, your more profitable investments will not create a meaningful value for you. As your capital is spread out thinly among the different investments, the impact of a healthy upside in one investment will turn out to be marginal. So, by over-diversifying, you are robbing yourself off the gains from the good investments.
Suppose you have 50 stocks in your portfolio. A 20% jump in one stock will only influence the overall portfolio performance by 2%. Sandip Sabharwal, CEO, portfolio management services, Prabhudas Lilladher, says, "For an investment to make a sizeable impact on your overall returns, it should form a reasonable part of your portfolio.
This should be judiciously concentrated, otherwise you will end up with average returns." Ajit Dayal, director, Quantum Mutual Fund, also believes in putting some weight behind his stock picks.
"In a fund, we try to have 25-40 stocks. If we like a stock and are convinced about its future performance, we support this conviction by buying enough of it to comprise 2% of the total corpus of the fund. However, many funds own nearly 100 stocks. We don't see any justification for this," he says. If you diversify too much, you won't lose heavily, but at the same time, you will not gain much.
Problem of plenty
It is cumbersome to maintain a huge portfolio and keep track of various investments. If you cannot monitor your investments regularly and need too much time to do it, you have clearly spread out thinly. In such a scenario, you may fail to notice a shift in the fundamentals of one or more of your investments. You may realise this too late, by which time the asset value could have eroded substantially.
No incremental benefit
There is a misplaced belief that with every additional security in the portfolio, the overall risk gets reduced to that extent. This isn't true. Studies have proved that diversification can help reduce the risk only to a certain extent. Beyond this, there is no incremental benefit.
Edwin J. Elton and Martin J. Gruber, in their book Modern Portfolio Theory and Investment Analysis, analysed that the average standard deviation (which is indicative of risk) of a portfolio holding just one stock was 49.2%. Increasing its size to 20 stocks brought down the risk to around 20%, thus reducing it by 29.2%. However, any addition in the number of stocks beyond 20 further reduced the risk by only 0.8%.
Paying more for the same
Investors often make the same mistake while purchasing mutual funds. All diversified equity funds have a basket of stocks, with the holdings spread across companies and sectors. Despite this, some investors choose to buy more and more such funds, each having at least 50-60 stocks in their kitty.
They end up paying more money for funds which are picking the same set of stocks. So they are duplicating their holdings without adding any value to the portfolio.
Hemant Rustagi, CEO, Wiseinvest Advisors, says, "Investors often buy funds blindly without giving a thought to individual fund strategy and objectives.
These funds mostly behave in the same manner when the market moves up or down." Dayal concurs. "Owning too many mutual funds does not necessarily give you the underlying diversification if all the schemes own the same kind of stocks. Many mutual funds tend to own the bigger, popular stocks, such as Reliance Industries and ICICI Bank ," he says.
If an investor were to invest in the top 10 equity diversified schemes, he would end up owning a portfolio comprising 136 stocks, with only 58 unique stock picks between them, while the rest of the stocks would overlap. As many as 10 stocks repeat themselves in more than 80% of the fund portfolios.
What's the optimum size for a portfolio?
The most essential question is, how much diversification is enough to achieve its intended goal and when does it start to become a burden? As Warren Buffett puts it, "Wide diversification is only required when investors do not understand what they are doing."
The extent of diversification varies depending on the investor's risk appetite, return expectations and understanding of the stock markets . According to Avinash Nahata, head, fundamental desk, equity research, Aditya Birla Money, the portfolio for an average investor should not have more than 20 stocks. Sabharwal agrees, "Empirically, it has been observed that 15-20 stocks lend optimum diversification to a portfolio. Beyond this, a portfolio becomes too stretched."
In the case of mutual funds, investors unknowingly and often fall into the trap of over-diversification. Subramaniam says, "If an investor owns 4-5 funds and 10-20 stocks, his total portfolio will probably exceed more than 100-120 stocks. This is the threshold level of desirable diversification. Beyond this, it is likely that the aggregate return on the entire equity holding (stocks and mutual funds) will mimic the market averages."
Experts agree that 4-5 diversified equity funds that have mid-cap and large-cap stocks should be enough. Sumeet Vaid, founder, Ffreedom Financial Planners says, "When investors buy more funds, the number of unique stocks becomes larger, sometimes numbering more than 90 stocks. The portfolio then starts to resemble the overall index, yielding sub-optimal returns. Instead, investors should diversify within the combination of 3-5 equity funds covering a range of stocks according to the company size."
If you have an unwieldy portfolio, it's time you pruned it and brought it back into shape. A nip here and a tuck there can help you streamline your investments, making them more manageable. But don't start getting rid of your holdings blindly. Here are the things you should keep in mind while consolidating the portfolio.
Don't sell the winners
The investors who have a difficult time keeping track of too many investments often end up selling their winning stocks while trimming their portfolios. Legendary investor Peter Lynch described this as "cutting the flowers and watering the weeds". However, this strategy of booking profits on winners is not always healthy, suggests Nahata.
"It is important to stay with winners for some time. To rebalance the portfolio, reduce those positions where your exposure is less, that is, low-value stocks. This will not only reduce the number of stocks but also make the portfolio more focused," he says.
Says Sabharwal: "If you get rid of your winners early, your portfolio will not be able to outperform. Instead, you should sell the smaller holdings."
Get rid of similar investments
Rustagi advises cutting down on funds with similar themes and 'flavour of the season' stocks. "Investors should identify and remove the funds and stocks that are similar to other existing holdings as they do not lend any diversification benefit.
Also, do not get carried away by betting big on stocks and funds that are currently the hot favourites," he says. For instance, it does not make sense to have a bunch of mid-cap-oriented equity funds. These will move largely in tandem with each other.
Be mindful of costs
Keep in mind that cutting down your portfolio to size will entail some costs. Every time you sell shares of a company or units in a mutual fund, you will incur a transaction cost. You must also be mindful of the possible impact of taxes and exit loads at the time of offloading these investments. It is advisable to stay invested for a reasonable time frame not only to avoid such costs, but also from the perspective of long-term returns.
Though portfolio consolidation will carry some unavoidable costs, the benefits of having a leaner portfolio will outweigh the cost of achieving it. "If portfolio consolidation is done in the right manner, what you get is optimised returns. Ultimately, the costs won't matter as much," believes Rustagi.
~
Source : ET
Instead of putting a large chunk of money in one asset and bearing a sizeable loss when its value plummets, it's better to spread the capital across various assets. If one of the these underperforms, the negative impact on the portfolio will be muted as the other holdings will, hopefully, do well. In case of stocks, you should invest in companies varying in size, industry and even geography.
But no matter how widely diversified a portfolio, the risk can never be eliminated entirely. So don't hoard investments blindly in the hope that you will tide over the market's uncertainties. At times, too much of a good thing can yield undesirable results; piling a large number of stocks and mutual funds may do more harm to your portfolio than good.
Says Vetri Subramaniam, head , equity funds, Religare Mutual Fund: "Diversification is a desirable goal for an investor. However, as you diversify, you not only reduce risk, but also the returns. So investors must keep this trade-off in mind." Here is how over-diversification can erode the performance of your portfolio.
Low impact of outperforming investments
If you have too many stocks in a portfolio, your more profitable investments will not create a meaningful value for you. As your capital is spread out thinly among the different investments, the impact of a healthy upside in one investment will turn out to be marginal. So, by over-diversifying, you are robbing yourself off the gains from the good investments.
Suppose you have 50 stocks in your portfolio. A 20% jump in one stock will only influence the overall portfolio performance by 2%. Sandip Sabharwal, CEO, portfolio management services, Prabhudas Lilladher, says, "For an investment to make a sizeable impact on your overall returns, it should form a reasonable part of your portfolio.
This should be judiciously concentrated, otherwise you will end up with average returns." Ajit Dayal, director, Quantum Mutual Fund, also believes in putting some weight behind his stock picks.
"In a fund, we try to have 25-40 stocks. If we like a stock and are convinced about its future performance, we support this conviction by buying enough of it to comprise 2% of the total corpus of the fund. However, many funds own nearly 100 stocks. We don't see any justification for this," he says. If you diversify too much, you won't lose heavily, but at the same time, you will not gain much.
Problem of plenty
It is cumbersome to maintain a huge portfolio and keep track of various investments. If you cannot monitor your investments regularly and need too much time to do it, you have clearly spread out thinly. In such a scenario, you may fail to notice a shift in the fundamentals of one or more of your investments. You may realise this too late, by which time the asset value could have eroded substantially.
No incremental benefit
There is a misplaced belief that with every additional security in the portfolio, the overall risk gets reduced to that extent. This isn't true. Studies have proved that diversification can help reduce the risk only to a certain extent. Beyond this, there is no incremental benefit.
Edwin J. Elton and Martin J. Gruber, in their book Modern Portfolio Theory and Investment Analysis, analysed that the average standard deviation (which is indicative of risk) of a portfolio holding just one stock was 49.2%. Increasing its size to 20 stocks brought down the risk to around 20%, thus reducing it by 29.2%. However, any addition in the number of stocks beyond 20 further reduced the risk by only 0.8%.
Paying more for the same
Investors often make the same mistake while purchasing mutual funds. All diversified equity funds have a basket of stocks, with the holdings spread across companies and sectors. Despite this, some investors choose to buy more and more such funds, each having at least 50-60 stocks in their kitty.
They end up paying more money for funds which are picking the same set of stocks. So they are duplicating their holdings without adding any value to the portfolio.
Hemant Rustagi, CEO, Wiseinvest Advisors, says, "Investors often buy funds blindly without giving a thought to individual fund strategy and objectives.
These funds mostly behave in the same manner when the market moves up or down." Dayal concurs. "Owning too many mutual funds does not necessarily give you the underlying diversification if all the schemes own the same kind of stocks. Many mutual funds tend to own the bigger, popular stocks, such as Reliance Industries and ICICI Bank ," he says.
If an investor were to invest in the top 10 equity diversified schemes, he would end up owning a portfolio comprising 136 stocks, with only 58 unique stock picks between them, while the rest of the stocks would overlap. As many as 10 stocks repeat themselves in more than 80% of the fund portfolios.
What's the optimum size for a portfolio?
The most essential question is, how much diversification is enough to achieve its intended goal and when does it start to become a burden? As Warren Buffett puts it, "Wide diversification is only required when investors do not understand what they are doing."
The extent of diversification varies depending on the investor's risk appetite, return expectations and understanding of the stock markets . According to Avinash Nahata, head, fundamental desk, equity research, Aditya Birla Money, the portfolio for an average investor should not have more than 20 stocks. Sabharwal agrees, "Empirically, it has been observed that 15-20 stocks lend optimum diversification to a portfolio. Beyond this, a portfolio becomes too stretched."
In the case of mutual funds, investors unknowingly and often fall into the trap of over-diversification. Subramaniam says, "If an investor owns 4-5 funds and 10-20 stocks, his total portfolio will probably exceed more than 100-120 stocks. This is the threshold level of desirable diversification. Beyond this, it is likely that the aggregate return on the entire equity holding (stocks and mutual funds) will mimic the market averages."
Experts agree that 4-5 diversified equity funds that have mid-cap and large-cap stocks should be enough. Sumeet Vaid, founder, Ffreedom Financial Planners says, "When investors buy more funds, the number of unique stocks becomes larger, sometimes numbering more than 90 stocks. The portfolio then starts to resemble the overall index, yielding sub-optimal returns. Instead, investors should diversify within the combination of 3-5 equity funds covering a range of stocks according to the company size."
If you have an unwieldy portfolio, it's time you pruned it and brought it back into shape. A nip here and a tuck there can help you streamline your investments, making them more manageable. But don't start getting rid of your holdings blindly. Here are the things you should keep in mind while consolidating the portfolio.
Don't sell the winners
The investors who have a difficult time keeping track of too many investments often end up selling their winning stocks while trimming their portfolios. Legendary investor Peter Lynch described this as "cutting the flowers and watering the weeds". However, this strategy of booking profits on winners is not always healthy, suggests Nahata.
"It is important to stay with winners for some time. To rebalance the portfolio, reduce those positions where your exposure is less, that is, low-value stocks. This will not only reduce the number of stocks but also make the portfolio more focused," he says.
Says Sabharwal: "If you get rid of your winners early, your portfolio will not be able to outperform. Instead, you should sell the smaller holdings."
Get rid of similar investments
Rustagi advises cutting down on funds with similar themes and 'flavour of the season' stocks. "Investors should identify and remove the funds and stocks that are similar to other existing holdings as they do not lend any diversification benefit.
Also, do not get carried away by betting big on stocks and funds that are currently the hot favourites," he says. For instance, it does not make sense to have a bunch of mid-cap-oriented equity funds. These will move largely in tandem with each other.
Be mindful of costs
Keep in mind that cutting down your portfolio to size will entail some costs. Every time you sell shares of a company or units in a mutual fund, you will incur a transaction cost. You must also be mindful of the possible impact of taxes and exit loads at the time of offloading these investments. It is advisable to stay invested for a reasonable time frame not only to avoid such costs, but also from the perspective of long-term returns.
Though portfolio consolidation will carry some unavoidable costs, the benefits of having a leaner portfolio will outweigh the cost of achieving it. "If portfolio consolidation is done in the right manner, what you get is optimised returns. Ultimately, the costs won't matter as much," believes Rustagi.
~
Source : ET
