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One of the foremost pieces of risk-management advice given to a stock market investor is: diversify your portfolio.
One might compare this risk mitigation move to the government pushing people to wear masks when they step outside their homes in order to minimize their risk of falling prey to Covid-19. However, can you imagine putting on five or six masks? After all, if one mask helps minimize your risk of contracting the virus, then five masks should be five times the protection, right?
As you might imagine – this is not the case. It is more likely that a person wearing five masks will have trouble breathing and cause himself or herself some other sort of problem. You don’t want to go overboard because you might suffocate. In the same way, over-diversification of an investment portfolio is also counterproductive.
Why we diversify in the first place
Let us understand why we diversify and how it helps minimize risk. The idea of diversification is to have slow growth and falling stock prices in some companies and sectors buffered by better growth and rising stock prices in other sectors. So perhaps F&B and infrastructure sectors take a hit while pharma and IT stocks experience good growth.
What is optimal diversification?
However, unless you have ‘exposure’ to a variety of sectors, you will not be able to experience the highs (and sadly also the lows) of their stock price graphs. Exposure refers to having investment in a certain stock or sector – how much exposure is ideal? Well, numbers vary between experts: some say 3 to 20; others say 20 specifically and some would rather go somewhere in the middle of this and say 8 to 12.
Remember that you also need to do sufficient research on all these stocks, so do pace yourself when choosing your stocks – you do need to diversify but you also need to pick stocks wisely. Picking your stocks slowly also helps you sidestep the possibility of over-diversifying. Now that we’ve recalled the purpose of diversifying in the first place and the optimal level of diversification, we’re ready to explore how the reverse can prove counterproductive.
The flipside of diversification – what happens when you cross the optimal diversification line?
- You might be killing your highs
The fact is that while you diversify to buffer the lows with the highs when you over-diversify, you end up buffering the highs too! With the lows. Some of your stocks might perform exceptionally well, but your overall earnings might prove to be rather lacking because of the falling stock prices of some other stocks.
- You have less time to conduct your research
This is true especially if you are an intraday trader but is also applicable if you are a short-term, mid-term or long-term investor. You must keep an eye on the annual reports, quarterly reports, balance sheets and other financials of the companies whose stocks you purchase. You must also keep up with news related to the companies and to the sectors that these companies operate in; you have to evaluate your stocks against the stocks of competing companies, stay up to date with allied sectors or commodities that might affect your stocks and you have to keep tabs on the overall economic outlook. Considerable time investment is required to achieve even a desired level of diversification. Over-diversification probably means that you are not providing sufficient time to research each stock individually.
- Over-diversification in mutual funds results in underperformance
Some mutual funds end up investing in hundreds of stocks on account of the tremendous cash flow (or capital flowing into the mutual fund). This flow of capital has to be supported by purchasing stock. The fund manager will carefully select the right stocks to be purchased at a given point in time. However, over time the fund is tracking so many stocks that the highs are buffered by the lows and the fund does not meet the performance of benchmarks and indices despite some of the stocks they are tracking doing so.
This is not only proof that over-diversification is counterproductive, but also a good reason to examine your mutual funds more carefully.
- By over-diversifying you might end up negating your diversification
Let’s say that every time you have some spare capital, you invest in a bunch of stocks from a variety of sectors. As time progresses, you might end up having almost all the energy stocks or too many telecom stocks or some such. At this point your exposure in some sectors becomes imbalanced – should the sector experience any issues that stunt growth and send stock prices plummeting, you will lose out correspondingly.
- Over-diversification might mean you’re treading on unchartered shores
It is possible that in your efforts to diversify, you are dabbling with sectors that you have difficulty understanding. It is unlikely that anyone understands over a dozen sectors right? That’s really pushing the boundaries of the kind of understanding that can typically sit inside the average investor’s head. Understanding 20 sectors would really take a genius. For most of us, 5 to 8 sectors would be as many that we’re able to wrap our heads around. Experts will usually advise investors to restrict their stock selections to sectors that they can follow and understand easily. This background is necessary for them to research their stocks sufficiently before investing.
It is always advisable to adopt a balanced approach to any stock market strategy that you are implementing. As you can see there is risk in overzealous risk reduction too! Never lose sight of stock market risk because it keeps you safe, but do consider the risk-reward benefits. To play it safe, invest with spare capital and ensure that you have another steady, dependable source of income. Most of all, remember that everyone can invest, irrespective of age, occupation and gender. You have already taken the first step of doing your research. Start your investment journey with Angel Broking and be sure to use our investor education platform to understand the stock market better before investing.
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