Risks vs Returns: How much portfolio diversification is too much?

Investment value in the equity assets tends to move with the performance of the overall market, i.e., the benchmark indices.Investment value in the equity assets tends to move with the performance of the overall market, i.e., the benchmark indices.

By Parthajit Kayal

In the search for better returns, equity-oriented assets such as mutual funds, Portfolio Management Services (PMS) and direct stocks have increasingly gained retail investors’ attention over the last few years. However, trying to achieve life’s important financial goals through this risky asset class is not an easy task.

The sudden experience of a financial market crisis and unexpected large financial losses has prompted many mature investors towards an unreasonable preference for fixed income assets like FDs, bonds, gold, etc. It becomes imperative for investors to understand the real impact of psychological states on their investment decision making. It forces them to adopt irrational choices that would have a damaging impact on their investment value over the long term due to low returns and high inflation.

Investors’ risk & reward preferences are asymmetrical
There is no doubt that we need to invest a large share of our funds in equity-oriented asset classes to beat inflation and achieve higher returns than fixed-income assets. However, the inherent volatility in equity investments and the fear of losing capital scare investors. After all, it’s their hard-earned money.

A common trait found in most people and also frequently discussed in behavioral finance literature is that investors’ risk and reward preferences are asymmetrical. They care far more about avoiding loss than they do about achieving a gain. Ultimately we all are risk-averse people especially when it comes to investment.

Multiple holdings may not reduce the risk but lower the returns
Appropriate diversification is important to protect ourselves from catastrophic financial losses and achieve relatively superior returns. However, immature investors might easily think that investment through multiple funds or stocks will automatically reduce the risk of loss. In that process, they choose several investment alternatives based on historical performance without giving much thought to the possible risk of capital loss. Therefore a simple addition of multiple stocks or funds would not necessarily reduce the future risk.

Instead, it could magnify the risk if investors’ choice of stocks and funds are directly or indirectly linked with each other. For appropriate diversification, it is not that more is always better as it could lead to over-diversification that can be an impediment for investment. It is a matter of fact that on average, a concentrated portfolio with fewer holdings is less volatile than more diversified funds and also earns relatively higher returns. Further, an over diversified fund or a portfolio rarely beats the benchmark.

Diversification does not alleviate market risk
Investment value in the equity assets tends to move with the performance of the overall market, i.e., the benchmark indices. The market could underperform due to factors such as recessions, political issues, natural disasters, wars, terrorist attacks, etc. This sort of risk is called market risk. Diversification cannot mitigate this market risk. Although we have no control over these events, a well-diversified portfolio can reduce the impact of this market risk and help us to recover the investment value faster.

Investment should be well distributed across sectors
Wide diversification is required only when investors do not have sufficient knowledge of their holdings. Investors may be better off buying a low-cost index fund in that case. Alternatively, they can choose three to four well-managed low-cost large-cap mutual funds. However, they need to keep their returns expectations in line with the index funds as holding three to four mutual funds is similar to holding a market index. In an ideal situation, 10 to 20 quality stocks in unrelated sectors would be the right choice.

Investors should have sufficient knowledge about the stocks they are holding to evaluate possible risks arising from each. That is feasible only when the number of stocks is limited. Investors can always reduce firm-specific risk by investing in quality market leaders from different sectors. Further, investment should be well-distributed across the sectors to avoid the risk of co-movements or covariance among stocks itself. It gives a balance against sectoral bias.

To sum up, diversification is desirable to reduce the risk but it could lower the returns. Therefore it is a matter of individual choice. A well-distributed portfolio of 10 to 20 quality market leader stocks from unrelated sectors could be optimum for investment.

The writer is assistant professor, Finance, Madras School of Economics

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