Diversification is killing returns

Summary: Think your mutual fund portfolio is diversified? Think again. From too many funds to too much of the same thing, clutter creeps in quietly. This deep dive challenges conventional thinking and helps you reimagine how a truly well-balanced portfolio should look and feel. You can’t have too much of even a good thing. Just ask Basil Brown, a health-food fanatic from the 1970s who drank a gallon of carrot juice every day for months. Sure, it is packed with vitamin A, but he ended up turning bright orange and damaging his liver. The lesson? Focusing on one “good” thing and ignoring everything else can backfire. The same mistake happens with mutual fund portfolios. Some investors go all in on mid-cap or sector funds. Others hold just one fund and assume they’re done. Then, some flaunt a collection of 12-15 funds, thinking more means better diversification. But in reality, they’re often paying different active fees for what’s effectively a portfolio with a high stock overlap. This story is your detox, not from picking funds, but from clutter. It’s about moving from complexity to clear, confident simplicity, where every fund earns its place and pulls its weight. Diversification isn’t about owning more funds; it’s about owning different kinds of funds. So when one part stumbles, and something always does, others can keep your portfolio steady. Why must you diversify? Just like a vegetarian thali contains a dal, a paneer dish, rice and salad, a proper investment portfolio needs to be diversified. That’s because it’s not solely about boosting returns; it’s also about insulating yourself in turbulent times. Owning a single fund might seem enough, but if your fund is leaning heavily into the same section of the market, say, small caps, you’re not truly diversified. Real diversification goes beyond quantity; it’s about variety. Because when the market turns, especially in crashes, being overexposed to just one flavour, like small caps, can leave a bitter aftertaste. The graph ‘When the tide goes out’ shows just how painful that can be, as small-cap funds have always fallen more sharply than an average aggressive hybrid fund, which is a better diversified fund because it invests in both equity and debt. Why do investors end up “diworsifying”? Peter Lynch, one of history’s greatest investors, once noticed something odd. US fund managers in the 1980s continued to add more stocks to their portfolios, hoping that extra names would somehow make them safer. He coined the term “diworsification” to describe the illusion of safety created by owning too many stocks, which often diluted their best ideas. Today, many Indian investors find themselves falling into this same trap. Their portfolios resemble crowded museums filled with funds that look different, yet hold essentially identical stocks. Imagine an art collector proudly displaying fifteen nearly identical paintings, convinced each is unique. That’s exactly what owning multiple overlapping funds feels like. You’re paying repeatedly for the same masterpiece, and it isn’t making you richer or safer. Then there are those investors who chase the trends. Like music fans assembling a playlist of only chart-topping hits, they rush to buy last year’s top-performing fund, add this year’s market favourite and finish off with the latest thematic offering everyone’s buzzing about. This isn’t entirely their fault. As Chart 2 illustrates, every time the market starts to rise, fund houses launch a frenzy of new thematic and sector-focused funds. Mutual fund distributors, eager for commissions, push these new launches aggressively, feeding investor excitement and creating the illusion of diversification. Investors feel secure owning a dozen or more funds, not realising they’re mostly buying variations of the same thing. In short, if your portfolio resembles a playlist of the market’s greatest hits, you’re not diversifying; you’re simply “diworsifying”. So, what does smart diversification look like? Smart diversification means covering your bases across different asset classes, sectors, styles, fund houses and geographies. Let’s break it down one by one. Across asset classes Investors often end up with wildly polarised portfolios, stuffed to the brim with just one asset class while ignoring the rest. And more often than not, that one asset class is either thrillingly risky or sleep-inducingly safe. Rarely is it suitable. Equity is usually the hero or the villain of the piece. For some, it’s an all-consuming obsession, every rupee in mid and small-cap funds, with dreams of doubling money every two y

This article was originally published on August 20, 2025.