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The Perils of Illusory Diversification

Unless done the right way, the diversification in your portfolio could just be providing a false sense of security...

Practically every investor is aware that diversification is something that is good for his or her investment portfolio. However, unless we care to get into the matter further, diversification is just a word. Most people have a vague idea that it means that one should invest in a large variety of stocks and funds. However, the way people put this into practice often leaves a lot to be desired—some things that pass for diversification are ineffective, or worse.

Recently, I received an email from someone who wanted me to check whether his portfolio for suited for his purpose. The email pointed out, with apparent pride that the portfolio was a very diversified one. Which it was, but only if you define diversification as being proportional to the number of stocks and nothing else. If a portfolio with 5 stocks is better diversified than one with two, then one with 50 stocks must be much better diversified than either, right? As it turns out, it isn’t as simple as that.

This particular portfolio had a bulbous head and a very long and thin tail, so to speak. The top stock was more than twenty per cent of the holdings, and the top 10 were more than three-fourths. The rest of the portfolio was basically tiny holdings of a large number of stocks. None of the stocks in this tail were capable of influencing the overall return. They could be great choices or they could be terrible ones—it wouldn’t matter at all in the larger picture. All they did was to create a manageability problem.

The situation was the same when one looked at the industry-wise breakup of this portfolio. One sector was more than one third of it and another two took the weightage of the top three to beyond the 80 per cent mark. There were a large number of other sectors, but they played no practical role.

Just a few days before this, and investor sent me a mutual fund portfolio that suffered from variation of this problem. This portfolio had about 20 funds, which, in my judgement, is actually more excessive than a 50-stock equity portfolio. This portfolio was also top-heavy but not because a small number of funds made up a big chunk but because a big chunk was made up of similar funds. Almost the entire portfolio was made up of mid-cap and small-cap funds. There were also some sector funds, some of them of the same sectors.

Both the above portfolios suffer clutter and excess, but it all starts with a poor definition of the goal of diversification among investors. The only utility of diversification is in saving you from poor performance in a narrow set of investments. If a particular company or sector is in problems, having only a limited exposure to it helps. Apart from sectors, diversification should also be across company size as sometimes only smaller or larger companies do well or do badly. It can also be geographical, which involves investing in foreign stocks, generally through international funds that offered by Indian fund companies.

Beyond a point, adding stocks or funds doesn’t materially add to the degree of safety but it does add to the problem of manageability. In the case of funds, the needs are even simpler, as each fund is itself a diversified portfolio. At its minimum, very little diversification is needed as there are plenty of good diversified funds that invest across sectors, company sizes and even geography. Balanced funds even add asset types by investing part of the assets in fixed income. All you need to do is to diversify across fund managers (and AMCs) in order to not get caught with one particular way of investing. Investors who wish to keep their life simple can do fine with just three or four funds. To sum up, diversification is not a goal in itself. It has its downside and is part of your workload as an investor. One should to the minimum required and no more.