DIVERSIFICATION – BENEFITS AND LIMITATIONS
Before we get into over-diversification, let us take some time to understand the reason for diversification. Diversification is a risk-management tool. The fundamental assumption behind diversification is that all asset classes or all assets in the same asset class will not underperform simultaneously. So, we can reduce the risk of our portfolio by matching asset classes who are negatively correlated expecting that the whole portfolio does not lose its value drastically at any point.
One should be clear that diversification does not eliminate all risk. Diversification eliminated the component of risk (idiosyncratic) which is unique to an asset or asset class. But, another component of risk which is correlated with the market (systematic risk) is never eliminated. So, it is possible that most asset classes start underperforming when the overall market is under a systematic strain such as a recession. Unfortunately, the correlated between asset classes seem to increase (making asset classes more correlated to each other) during economic distress and all asset classes start underperforming together. This is called Contagion.
WHAT IS OVER-DIVERSIFICATION?
Over-diversification is holding too many assets in our portfolio in very small proportions losing sight of individual performance of the asset classes or assets. It is may give us a sense of emotional security due to the assumed reduction of risk, but over-diversification actually hurt our portfolio.
WHY WE END-UP OVERDIVERSIFYING?
Most investors do not understand the role of different asset classes in a portfolio. It is not just about return and risk. In short, equity offers long-term growth, debt instruments offer lower market risk and income, money market securities offer liquidity.
You can learn more about asset allocation here-
The second reason is lack of investment planning. If we do not know why we are investing we will invest in everything to cover all bases. We often start investing because our friends and investing and we do not like to miss out. This is good but defining our investment objectives should be the first step.
The third reason is loss aversion bias. The psychological pain of losing Rs.100 is much more than the satisfaction of gaining Rs. 100. This bias makes us do irrational things. We over-diversify so that our portfolio does not show an overall loss at any point – even if that loss is completely on paper.
WHY AVOID OVER-DIVERSIFICATION?
Risk comes from not knowing what you're doing.
- Warren Buffett
Many prominent investors do not diversify their portfolio. One reason is that they spend an immense amount of time researching about the company they are investing in. Over-diversification is the insurance for our ignorance. The problem is that over-diversification may become an excuse for not doing any research.
Another reason is that diversification reduces the probability of outperforming the market. The closer your portfolio to the market the lower the chances that your portfolio outperforms the market- which is not a bad thing for most investors.
The most important reason is that diversification increases the cost significantly. As mentioned above, over-diversification reduces the chances of outperforming the market. Most investors may not want to outperform the market but over-diversification increases the cost of getting market return much much more.
An investor may achieve market return simple investing in ETFs or Index Funds and not creating a complex portfolio of equity mutual funds. The Total Expense Ratio (TER) for an ETF is in the range of 0.05%-0.10%, the TER for an Index Fund is in the range of 0.15%-0.20% compared to the TER of Equity Funds of 2.25% -2.5%. Apart from that, managing various funds takes a lot of time and effort.
Note: Investing in ETFs require brokerage charges, demat account and Securities Transaction Taxes.
We can see that we can drastically reduce our cost by replicating the market using ETFs or Index Funds and not bothering about too many mutual funds.