Avoid over-diversification of equity funds

If ever there was a golden investment rule to remember, it's "not to put all eggs in one basket." Every investment is subject to uncertainties of environment. If you're invested only in one asset class or a single sector, the concentration of risks are very high and this could lead to sub-optimal or negative returns in case of any unforeseen incident. For instance, during the technology bubble of early 2000, thousands of investors ignored this golden principle and were significantly invested in the technology sector. When the bubble burst, they suffered heavily.

This is all the more relevant in today's equity markets where duration, intensity and frequency of changes in stock prices become difficult to predict considering the impact of global events and psychological bias besides corporate fundamentals and business cycles. At a given point, some sectors of the market might do well while others may lag behind. For instance, when there is weakness in the Indian currency, export oriented companies flourishes while import oriented companies suffer.

Mutual funds manage concentration risks effectively through diversified stock portfolio while pursuing a specific investment style or a theme. Besides reducing concentration risk, a well-diversified portfolio has two inherent advantages. One it limits emotional investing. Emotions comes naturally to all of us across all spheres of life including investments. Diversification also reduces the element of emotional bias by keeping exposure limits on sector and stock selections.

Secondly, periodic re-balancing ensures profit-booking from performing investments and encourages increased investments in sectors which are likely to perform in future.

This now brings us to the common questions that investors often ask is how much of diversification is optimal? How many funds are enough? Do they need five or fifteen funds in their portfolio?

Most financial advisors agree that there is no specific mantra or formula to decide how many funds an investor should have an exposure to. However, according to market research, the average returns for a portfolio of equity funds are more or less the same whether they hold five or forty-five funds. This means that beyond a point adding funds don't incrementally benefit portfolio returns.

Hence, while a diversified portfolio has immense benefits of reducing concentration risks, limiting emotional investing and generating optimal returns, at the same time, over-diversification can be equally counter-productive as it offsets the balance, makes investments sub-optimal, as it does not provide additional value and increases management time.

Here are a few guidelines to follow while deciding your mutual fund investments:
Goal-based investing: Identify your long term financial goals and earmark investment funds for each identified goal. Decide your investment asset class basis your risk appetite and investment horizon and then split the investment amount allocated for one goal into 2-3 funds.

Recently, the craze of NFOs might make you think that you should add one or two new schemes to your overall portfolio, or that there may be a compelling theme you are missing. If a NFO is replicating what's already available in the market, there is no point considering it. The focus should always be on achieving your long term financial goals.

Optimal diversification is the key to success: There is no need to buy funds from all fund houses, as diversification can be achieved through exposure to 3-4 fund houses. According to most certified financial planners 3-4 funds within the large-cap category and 2-3 within the mid-cap segment are good enough and can effectively meet your long-term wealth creation goals while offering optimal diversification. If the funds you hold already are performing well and you are satisfied with the overall experience, there is no need to change; just add incremental investments to the same folio. Administratively, too, it is easier to maintain fewer folios.

Do not chase performance alone: If you analyse the performance of diversified equity funds over the past 3-5 years, you will find that every quarter, different funds are the top five performers (in terms of 3 and 5-year returns). This indicates that no one fund can be the best or the second best. So, if you buy only on the basis of performance, you may end up adding a new fund to your portfolio every six months or a year. This would lead to over-diversification.

The author is the Senior Group President at YES Bank