Diversification of investments according to varying degrees of risk and returns is a cornerstone of any prudent investment strategy. Spreading your investments into different instruments to offset combined risk and to stay afloat in order to gain expected returns is a tried-and-tested thing. However, overdefensive investors often go to the other extreme while trying to weave a safety net around their investments. They allocate their investments in far too many products, something that jeopardises the growth potential of their entire investment portfolio.
This is called over-diversification of investments. Let’s see how over-diversification can damage the health of your investment corpus:
The idea behind diversifying investments into different asset classes and products is to minimize the overall risk factor at the cost of marginally losing out on expected returns. Meaning, the performance of the low-risk low-return investments will offset the losses incurred, if any, by the underperformance of riskier investments, hence preventing the investment boat from sinking altogether.
However, when someone invests in too many products, the degree of this risk-correcting marginal loss on expected returns increases – to an extent that it starts eating into the marginal benefit of risk-reduction. As such, over-diversification can turn out to be a self-defeating exercise by impacting your expected returns. The overall counter-risk benefit can be too feeble and negligible to help meet your financial goals in time. Moreover, the problem can get complicated further when you evaluate your overall returns through the prism of inflation and tax.
Your investment portfolio should be managed in such a way that you’re always on track in your journey to meet your financial goals. And earning investment returns which are in line with those goals is the most crucial milestone that you need to cross in this journey. Handling the risk of investment is crucial too, but not at the cost of not meeting the goals by losing on expected returns.
The key is to take a balanced position while trying to spread out investments to mitigate overall risk. But over-diversification, like anything in excess, doesn’t really help the cause. In fact, it has the potential to adversely impact your financial goals by hurting your expected returns.
After all, compromising on returns to minimize losses shouldn’t be so big that you stop making gains altogether.
The other major problem lies with the practical aspect of over-diversifying your investments. It can get unmanageable to keep track of and evaluate the performances of too many investments. More so because a number of active investment tools (like stocks, commodities, and even certain mutual funds) may require constant monitoring and re-calibration, and it could be virtually impossible for most investors to make quick, informed calls when it comes to so many investment instruments. So it’s better to stay invested in only those many instruments that can benefit from the investor’s expertise and are aligned with the investor’s risk profile and financial goals.
The good old notion that “quality is better than quantity” holds true even when it comes to diversification of investments. As such, to reduce the combined risk factor of investments, choose only the instruments that you’re well-versed in and organize your investments in such a way that you won’t deviate too much from earning the expected returns even if some risky investments underperform. Putting safety valves is important, but only in moderation, as too many valves may block the water supply altogether.
As such, the optimal diversification of investment can be secured if the portfolio is distributed only among meaningful instruments according to the investor’s financial goals and risk profile. But getting carried away and over-diversifying your investments will either delay your journey to earn expected returns or result in overall losses.
Don’t forget: they say “too many cooks spoil the broth” for a reason.
(The writer is CEO, Bankbazaar.com)