In this chapter of the Classroom, CNBC-TV18 Consulting Editor Udayan Mukherjee explains the advantages and disadvantages of portfolio diversification
Q. Is diversification important in constructing a stock portfolio?
A. Diversification spreads risk. This follows from plain arithmetic. If there are only 3 stocks in one's portfolio and one of them tanks like say a Yes Bank, the overall portfolio takes a massive hit. A 80% fall in any one stock would, the others being unchanged, dent the portfolio value by 26%! However, if the same portfolio had 10 stocks, the fall would only have been 8%. Bad, but not disastrous. Diversification also enables participation in different themes and industries. All sectors do not perform well at the same time. Sometimes consumer stocks do well, sometimes industrials do while sometimes it is the turn of export industries. A diversified portfolio ensures that some stocks perform well and negate the slack of underperforming sectors, ensuring decent average returns while cutting risk. Thus, some amount of diversification is important to build into any long term portfolio of stocks.
Q. What are the risks in having too diversified a portfolio?
A. Too much diversification can hamper portfolio returns. If a portfolio has twenty stocks from twenty different sectors, it may reduce risk but also limit the investor's participation in a theme that is performing well. For example, in the last major market upmove banks were the big leaders. If however, an investor, for the sake of diversification, owned only one banking stock, his portfolio would have underperformed the market indices significantly. It's thus wiser to choose a few specific themes and be well exposed to each of them, rather than chase diversification for the sake of it.
Q. What are the pros and cons of a concentrated portfolio?
A. Professional investors, even Portfolio Management Servives (PMS) often run fairly concentrated portfolios. Anything between 6-12 stocks counts as a concentrated portfolio. This is because high conviction stocks bets can often lead to superior returns, if the weightage of a winning stock in the portfolio is high. It is the opposite of the high risk carried by a similar portfolio. If in a five stock portfolio, one stock doubles in quick time even as the other four remain unchanged, the portfolio value would shoot up 20 percent! Therefore when the level of conviction is high, a concentrated portfolio may not be a bad thing. However, if an investor is very bullish on a particular sector, or understands that sector better than others, and therefore loads up on that to the exclusion of others, the portfolio can take a huge hit if that sector goes through a downturn. So, while constructing a concentrated portfolio, this risk needs to be kept in mind.
Q. What is the ideal number of stocks in a portfolio? What bearing does it have on returns?
A. There is no one ideal number. But the sweet spot could be between 10-16 stocks. In such a scenario, each stock would roughly have a weightage of 6-10%, not too high to be risky yet enough to influence the overall returns. A tight number of stocks usually affords the opportunity of knowing/researching the companies better and remaining tuned to changes and developments. As individual weightages grow or reduce, depending on how stocks are performing, the investor can take a call on pruning or adding to positions. The mistake many investors make is to keep on buying stocks and adding to the portfolio, responding to tips and suggestions from friends or the media. At the end of a period of time, the portfolio has dozens of stocks, skewing weightages and dampening overall returns for reasons mentioned earlier.
Q. Should one also diversify one's portfolio of mutual funds for better returns?
A. There are two aspects to this. One, it is important to invest in a few mutual funds, not one. There are various kinds of mutual funds with very different objectives and investment styles. Large cap funds, midcap funds, sectoral funds and so on. Different fund managers have different styles. Some prefer value stocks with depressed valuations, others like fast growing companies even at high valuation multiples. All themes cannot and do not perform equally well at the same time. Therefore, like in stock selection, it's prudent to own a basket of mutual funds. A couple of stable large cap funds investing in blue chips, one or two midcap or small cap funds for more adventurous bets, maybe even a sector fund if a particular sector is high conviction for the investor and different fund manager run portfolios.
Two, it is important for investors to check the portfolio of mutual funds to see if they themselves are too diversified. Often, mutual fund managers diversify so much, for fear of underperforming their competitors, that their returns begin to veer close to the benchmark indices. In such cases, simply buying a lower cost index fund makes sense. In recent years, mutual funds have not easily managed to beat the Sensex or Nifty.
(Udayan Mukherjee’s second novel ‘A Death In The Himalayas’, published by Pan Macmillan, has been released. For more details, click here)
More in this series: Why markets exist, and should I invest in stocks? Starting your stock market journey Can I get rich fast by investing in shares, and other questions How to open a Demat account and select a broker Dealing with the stockbroker Placing orders Where should I invest and how? Cheap or expensive: How to value a stock To subscribe or not to subscribe? All about IPOs What is short-selling and how can I profit from a fall in stock prices?
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