Over diversification is an aspect of portfolio building where investors usually end up adding an unnecessary number of stocks and/or mutual funds. An excessively diversified portfolio is invested in so many different vehicles or so many different asset classes that it limits the possibility of higher gains for no additional reduction in the levels of risk. This not only sometimes negates the returns from high performing securities but also lowers the quality of the portfolio build over time.
More often than not, investors tend to add assets in the portfolio that might not add any significant value to the portfolio. For example: too many mutual fund schemes of the same sector, investing in all the mutual fund schemes of only one particular fund house, investing only in large cap schemes, etc.
On numerous occasions, investors tend to accumulate miniscule corpus in varied overlapping mutual fund schemes which consist of identical stocks, thus exposing the portfolio to fatal risk in case of underperformance. This has a negative effect on the return expectation and leads to an increase in expenses due to frequent buying and selling. The entire purpose of diversification is beaten due to a complex and overlapped portfolio.
Below Average Returns
Quality of the portfolio suffers due to over diversification. An army of 70 under performing stocks can significantly dampen the expected returns when bundled with 10 market soaring stocks as portrayed in the example below:
A highly over diversified portfolio is more time consuming to track and follow. It not makes an investor lose focus on how the money is invested but also makes it extremely difficult to review a plethora of investments on regular bases or track performance in order to make necessary changes in the strategy. A consolidated portfolio shows the investors conviction in the funds or stocks already in the portfolio and has a significant impact on meeting his financial goals.
Diversified investments promise less risk but an over diversified portfolio guarantees lower returns for no additional reduction in risk. An investor thus needs to inculcate a suitable asset allocation strategy which is linked to the financial goals and risk profiling of the individual.
Core and Satellite approach may be adopted wherein:
Core forms the maximum portion of the portfolio which is linked to an individual’s long term goals and remains intact during the investment term.
Satellite forms the remaining portion of the portfolio which can be approached in a tactical manner to make gains from the market opportunities.