By Kush Gupta
While diversification reduces risk and creates long-term sustainability in investment portfolios, over-diversification can often lead to the dilution of investments in quality stocks. Your portfolio mix should meet a certain purpose or a specific goal instead of just accumulating funds.
Focused mutual funds have, on average, 25 to 30 stocks, whereas large-cap funds have, on average, 75 to 80 stocks. If you look at three-year returns, large-cap funds have stayed in the range of 11 to 13%, while focused funds have delivered 17 to 19%.
It is important to understand why this happens. Over-diversification means investors expose themselves to the entire breadth of the stock market by accumulating 150 or even 200 stocks across their diversified mutual fund portfolio. The broader market usually does not deliver very high returns because sectors have their own up and down cycles.
Meaningful diversification means that every mutual fund or stock included in a portfolio provides complementary support towards the investor’s desired returns. For example, if one wants to diversify risk, they can select one large-cap fund, one mid-cap fund, one small-cap fund and one balanced fund. However, if they accumulate multiple funds from the same category, it would unnecessarily dilute investments.
Overlap leads to dilution
Let’s discuss how overlap leads to dilution. If you pick some of the biggest large-cap funds, you will notice that all of them have over 30% exposure to the financial services sector. They also have over 15% exposure to the consumer sector. This means nearly 45% of the investments are going into the same bucket.
If you accumulate multiple large-cap funds, almost half of your portfolio becomes dependent on just two sectors. If there is negative sentiment in these sectors, your returns are likely to suffer. Many investors think that accumulating four or five funds from the same category will improve the chances of better returns. However, Indian markets are not broad enough, and returns across the large-cap space largely remain similar.
Finding the right portfolio mix
Overlap also increases complexity. If you hold multiple funds from the same category that perform broadly alike, it becomes difficult to decide which ones to retain. For investors without access
to extensive research, identifying which sector or company is negatively impacting the portfolio becomes even more challenging.
Each category has a specific function depending on market sentiment, risk profile and macroeconomic factors. Investors should ideally stick to one fund in each category. If markets are expensive and risky, balanced funds may be suitable. If earnings growth is expected and the economy is booming, flexi-cap or mid-cap funds may be more appropriate. Long-term equity investors can rely on large-cap funds for stability, while investors with a higher risk appetite may bet on focused funds.
The writer is director, SKG Investments and Advisory
Disclaimer: This article is for informational purposes only and should not be construed as investment, financial, tax, or legal advice. Any illustrations, examples, or return projections used in this article are for explanatory purposes only and do not guarantee actual investment outcomes. The views and opinions expressed by experts quoted in this article are their own and should not be considered investment recommendations. Readers should consult a qualified professional before making any financial decisions.
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