Diversification: How to get it right

In his treatise the Arthashastra, Chanakya suggested a method to reduce the loss caused by the theft of high-valued items. In those times, the market for high-valued goods barely existed and their export used to be highly risky. He said that such items should not be shipped together. Rather they should be distributed across several shipments and with other regular items. So, even if dacoits plundered a batch of shipments, the loss would be contained. Indeed, Chanakya was talking about diversification. Diversification is one of the most important elements of the investing process. Simply put, it means 'don't put all your eggs in one basket'. This basic advice makes sense as the opposite of it would be clearly risky - concentrating all your resources in just one investment. What if that one investment performs poorly? What if it turns out to be a disaster? Of course, there are some savvy investors who profess focusing because that enhances the overall outcome, yet for most investors, diversification remains a sensible tool to reduce risk. The next question is how much diversification is enough. Value Research has always said that fund investors would do well with just four-five funds in their portfolio. But the reality appears to be quite different. From investor portfolios created on www.valueresearchonline.com and from the queries that we receive, we have realised that the average investor has far too many funds. There are many reasons for this, including chasing past performance or some hot theme, not exiting poor performers, not keeping a tab on the portfolio, etc. But one reason that stands out is many investors feel that the more the funds they have, the better the extent of diversification. As we have long maintained, adding more funds beyond a threshold contributes little to diversification but does increase the headache of managing the portfolio. In this story, we try to assess how many funds are needed for sufficient diversification. For that, we have done a comprehensive analysis, encompassing lakhs of datapoints. Methodology In order to assess how many funds are required to achieve sufficient diversification, we considered multi-cap funds that had a 10-year history as the sample universe. There were 28 such funds. Next, we made portfolio combinations from these funds, with number of funds in the portfolios varying from two to eight. The table 'Portfolio combinations' mentions the total possible combinations. For each portfolio combination, we considered a monthly SIP of equal amounts in each of the funds. This SIP was done for a 10-year period. An annual re