Here's why over-diversification in your portfolio tends to reduce returns

Know why over-diversifying one's portfolio can result in reduced returns

Portfolio over-diversification and great returns don’t go hand-in-hand!

Conventional wisdom in investing advocates diversification of one’s portfolio to minimise unsystematic risk. This is based on the underlying principle of finance that high risk translates into a high return. Thus, in case of a weighted average basket of asset classes comprising low, moderate and high returns, the risks would also be balanced out in the long run.

According to probability theory, uncorrelated asset classes would result in reduced price volatility with a lower risk of substantial loss. However, how much diversification is too much? In fact, some of the most successful investors of our times have termed diversification as a tool adopted by those who have limited knowledge of the workings of the investment instruments.

“Diversification is a protection against ignorance. Wide diversification is only required when investors do not understand what they are doing.’’- Warren Buffett

Related: ​​​​6 Practical strategies to help reduce investment risk

The simple logic is that by spreading oneself too thin, one might not be able to devote sufficient time to study the risk-return trade-offs associated with a particular investment avenue. Thus, one might end up investing merely by hearsay or after half-hearted due diligence, without adequate homework. This might result in buying sub-optimal securities that generate low returns in the long term. 

Let’s look at the specific reasons why excessive portfolio diversification results in reduced returns and why it makes sense to change your investment strategy right away.

1. Quality over quantity: It’s no secret that successful investing requires buying quality stocks with growth potential, at reasonable prices. Thus, it is imperative to choose asset classes that one is familiar with and can understand. For example, in equity investing, it is prudent to buy stocks in sectors that the investor understands so as to be able to time one’s transactions and book profits correctly. An investor can derive higher returns from a few performing stocks than by blindly accumulating multiple stocks that yield poor returns. In other words, for superior returns from investing, one needs to go deeper, not wider.

2. The devil is in the detail: Financial investing decisions involve extensive study and comparison of returns between investment products, depending upon the investor’s risk appetite. Thus, with multiple assets, while the unsystematic risk would be minimised, the other risks might dominate and result in poor returns. Ultimately, the risk and returns need to be evaluated standalone for each investment avenue and cannot be clubbed for comparison.

Related: How to diversify your portfolio like an expert?  

3. Constant reallocation is the key: To beat the market, it is essential to periodically study one’s portfolio performance and re-orient one’s monetary allocation between the asset classes. This would be possible if one has a limited size of investments. Over-diversifying into multiple investment avenues can result in a bulky portfolio that is unwieldy and unmanageable. Beyond this point, the marginal loss from expected return would exceed the marginal benefit of lower risk, which would be counterproductive in the long run.

4. Statistical evidence points to the downsides of over-diversification: In Edwin J. Elton and Martin J. Gruber’s book, Modern Portfolio Theory and Investment Analysis, a study revealed that the average standard deviation (volatility risk) of a single stock portfolio was 49.2%. Increasing the number of stocks in the portfolio could reduce the portfolio's standard deviation to a maximum of 19.2% (market-related risk). Further, it was discovered that in a portfolio comprising 20 stocks, the risk was reduced to around 20%. In conclusion, the addition of stocks over 20 and up to 1000, reduced the overall portfolio’s risk by a meagre 0.8%. On the other hand, the first 20 stocks reduced the portfolio's risk by 29.2 %. Thus, there was a disproportionate drop in risk with each addition of stock to the current holdings. This reinforced the concept that one can reduce risk by diversification only until a certain limit.

Related: 5 Mistakes to avoid while investing in a bull market

Nowadays, with a plethora of investment options to choose from - equity, debt instruments, mutual funds, fixed deposits, PPF, NPS, ELSS and other combinations of high-risk equity etc. it’s easy to get overwhelmed. In the end, a well-balanced portfolio with optimal diversification can help generate good returns in the long run. While there is no thumb rule as to the optimum size of investments to be held in a portfolio, experts recommend 15-30 different assets as optimal to eliminate unsystematic risk. It would do well to remember Mark Twain’s words in the context of over-diversification and its disadvantages - “Behold, the fool saith, "Put not all thine eggs in the one basket" - which is but a matter of saying, "Scatter your money and your attention"; but the wise man saith, "Put all your eggs in the one basket and - WATCH THAT BASKET." Here are some simple ways in which you can diversify your financial portfolio. 

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