In the overall scheme of investor problems, over diversification isn't the worst sin. Having too many holdings won't wreak the same havoc that undersaving will, or performance-chasing.
Nevertheless, at Morningstar we believe that there's a practical risk to being too diversified. When you own too many stocks and mutual funds, it becomes nearly impossible to get a good knowledgeable grasp on each holding. When you lose your focus, you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things.
Christine Benz, Mornigstar’s director of personal finance who is based in Chicago, says that for every single portfolio she receives that is whippet-thin -- without an excess stock, fund or ETF to spare – she comes across 10 more that have 50, 60 or even 100 individual holdings. She refers to over diversification as portfolio sprawl and believes that it can add to investors' oversight challenges.
It can simply be difficult to keep track of the fundamentals of so many holdings, especially if those holdings include individual stocks along with actively managed mutual funds of various categories. The investor with too many holdings may have trouble figuring out asset allocations or knowing when or how to rebalance.
No matter how logical an investor you believe you are, you could get carried away and buy on whims or fall for the latest market craze. Some investors pick up certain funds or stocks which have a “cult status” so to speak. Splintering your portfolio into too many different funds and can dilute the impact of any one investment. An overdiversified portfolio can stunt returns and amplify risk. By blindly assuming more is safer, overdiversification gives a false sense of security.
Cut off the excess
You need to diversify smartly. Having a glut of funds is not smart diversification. For instance, a portfolio with three mid- and small- cap funds, three sector funds, an index fund and three large-cap funds is not a well diversified one just because it has 10 funds.
Does the index fund track a large-cap index such as the Nifty or Sensex? That would translate into four large-cap funds. Are three sector funds necessary when the other funds are diversified equity funds investing in all the relevant sectors? Does one need an exposure to three different mid-cap funds or would two just suffice – one with a value blend and the other with a growth tilt? Does the overall portfolio have sufficient debt exposure since none of the funds are balanced or debt oriented? Such questions would need to be answered when viewing the portfolio as a whole and preferably with the help of a financial adviser.
When trimming the flab, view in totality your portfolio of equity, debt and tax planning instruments.
Consolidate the portfolio
Reduce the number of holdings in your portfolio and ensure that each is best of breed. But don’t focus exclusively on trailing returns. If you find duplicative holdings in a similar space, the natural tendency is to kick to the curb the one with the lower trailing returns. By focusing disproportionately on investments with happy-looking trailing returns -- especially over the past 1 to 3 years, investors may inadvertently tilt their portfolios toward higher-risk, higher-volatility investments. To understand how to use returns in streamlining your portfolio, read Does past performance matter?
Investing in stocks directly
Many investors use mutual funds for the bulk of their portfolios while also maintaining a smaller basket of stocks on the side. If that describes your setup, reflect on your past behaviour and performance as a stock investor. If you have tended to do your homework on your companies and have generated strong performance with this part of your portfolio, that may argue for making individual stock holdings an even larger part of your portfolio than they already are. But if you have amassed a portfolio of individual equities more haphazardly -- and monitored them not at all -- it's a good time to ask yourself what those small positions are actually doing for you. If your total position is fairly small, it's adding to the clutter in your portfolio but doesn't have the potential to dramatically alter your bottom line, for better or for worse.
It is not without reason that diversification is referred to as the only free lunch in investing. But it is possible to have too much of a good thing.
