Here's why you should not over-diversify your portfolio

Rahul Jain, President & Head - Personal Wealth, Edelweiss Wealth Management.

A diversified risk management strategy lends stability to your portfolio and helps it ride choppy waters with it. A core tenet of investing, diversifying across asset classes and within assets, helps hedge risk and bolsters portfolio performance.

However, often in the name of diversification, investors tend to go overboard and end up investing in too many stocks. It's not uncommon to find investors having 50 or more stocks and funds in their portfolios. Ask them the reason, and they would say that they did it to diversify their investments. They couldn't be more wrong.

Just as you need to ensure that your portfolio is optimally diversified, it's equally essential to guard against over-diversification. Why? Let’s find out.

Difficult to Track Returns

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Rahul Jain

President & Head, Personal Wealth|Edelweiss Wealth Management

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Tracking the returns of your investments periodically is crucial to gauge their performance and make sure whether they are in line with your expectations or not. However, when you add too many stocks to your portfolio for the sake of diversification, tracking returns becomes a tall order.

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It allows non-performers to escape the scrutiny net, which hampers long-term wealth creation. Too many overlapping stocks or funds make your portfolio unwieldy, which is harmful in the long term.

Dilutes Returns

It is another flip side of over-diversification. When you end up adding too many stocks of similar nature in your portfolio, it drags dilutes returns to a great extent. For instance, if your portfolio has 4-5 stocks of different market caps, it bolsters chances of earning high returns.

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This is because the investment process of each stock is different. However, if you invest in 100 stocks of similar nature, the same dilute returns significantly. On the other hand, a few selected stocks provide your portfolio with much higher levels of diversification without compromising on returns.

Leads to Unnecessary Complications

When you over-diversify, it makes your portfolio bloated and leads to unnecessary complications. It leaves a lot of room for confusion. However, things are radically different when you keep them simple. There are fewer chances of investing in wrong stocks that can erode capital in the long run.

Therefore, the mantra is to keep it simple and not add more than five to six stocks to your portfolio. Simplicity will help you be on top of your investment and better control them.

To mitigate the threat of over-diversifying, analyse if a financial instrument or stock adds any real value to your overall portfolio. For example, if you already own a technological and banking stock, it makes little sense to invest in a fund investing in these two sectors. Being logical in your thinking and adopting a rational approach towards investing can help you steer clear of the pitfalls of over-diversifying.

Summing it Up

Your capacity to understand and analyse investments goes a long way in mitigating the threat of over-diversification. If you don’t understand the logic behind a particular investment, avoid it at all costs.

While optimal diversification ensures you are on a solid financial footing, over-diversification leads to unnecessary hassles that rob growth potential of your portfolio and your peace of mind.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.