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Portfolio Diversification How much is too much
Portfolio diversification is the new buzzword today, and most investors blindly follow this portfolio management strategy, without a proper understanding of its key fundamentals. While a balanced portfolio diversification is essential to reduce the risks associated with your investments, over-diversification can negatively impact your financial goals. As an investor, you should exercise due diligence and have a proper understanding of the components of your portfolio. Besides, you must ensure that the portfolio is in sync with your financial objectives.
Understanding portfolio diversification : Portfolio diversification in stocks implies investments across different industries and sectors. This is done with the key objective of reducing risk exposure. It has been proved that spreading investments across several unrelated sectors will help you reduce the associated risk.
Understanding over-diversification : Over-diversification occurs when the advantage of reduced risk exceeds the expected loss of returns. Whenever you invest in a new stock, it will marginally reduce the risks. But simultaneously, it also reduces the expected returns. For instance, if you have purchased 100 different stocks, it will reduce risk. But, this will also mean lower returns as you don’t have an optimum number of high-performing stocks. This can also result in a situation where you face zero profits and zero losses. This beats the fundamental reason for making investments.
Alongside, many investors have a notion that with every new stock, there is corresponding reduction in risk. This, is, however, a wrong portfolio management strategy, as the overall risk factor can be eliminated up to a certain point. Remember, while the risk associated with individual stocks, known as unsystematic risk can be significantly reduced, there are also inherent market risks, known as systematic risk, which will invariably impact the stocks. In other words, you can never completely eliminate systematic risks.
The way out : optimum portfolio diversification — Market experts suggest a portfolio management strategy, where you have an optimum number of stocks – up to 20 – which are spread across various unrelated industries and sectors. While this will help you reduce the unsystematic risk, it will also help you get better returns from a basket of high-performing stocks. An optimum portfolio diversification also helps in getting dependable performance as at any point of time, some sectors and industries might be facing a difficult situation, while others could be flourishing.
Understanding overall portfolio diversification : This means that apart from stocks, your investment portfolio should also comprise various asset classes. These could be real estate, gold, bonds, alternative assets, commodities etc. You can allocate a specific percentage of your investments – as per your individual goals – in these asset classes. Here, you should again remember to spread your investments across the various asset classes. You should also keep in mind that institutional vehicles such as diversified mutual funds, ETFs, equity index funds, diversified mutual funds and so on are already over-diversified in nature. So they are unable to generate optimum returns. Focusing on quality vis-a-vis quantity is the key when it comes to overall optimum portfolio management.
Conclusion : Thus, while portfolio diversification is a time-tested method to reduce risk, it is of paramount importance to guard against over-diversification. Along with diminishing the returns from your investments, an over-diversified portfolio will also require an enormous amount of time and resources for its monitoring and management. An optimum portfolio diversification is the key to successful investments.