Managing Risk: Avoid Over Diversification in Mutual Funds
Diversification is an important method for reducing investment risk by spreading investments over multiple assets. While diversification is necessary to protect against losses and market volatility, too much diversification can dilute portfolio performance. When determining asset allocation, experts advise investors to consider criteria other than age, such as risk tolerance, investment horizon, goals, and liquidity requirements.
What is an Over Diversified Portfolio?
Over-diversification in a mutual funds portfolio occurs when an investor attempts to reduce risk by investing in an excessive number of mutual funds. Over-diversification can diminish return potential while not lowering risk. Excessive diversity can be harmful, resulting in a portfolio that is worse off as incremental investment returns diminish.
Owning Too Many Similar Funds
Similar funds and strategies can be shared by mutual funds that go by different names. Several funds owned in the same style category result in higher operational work, more research and still lower returns. Compare the style categories of your funds to make sure that you don’t invest in too many funds from the same category. The thumb rule says that 2 funds from one category are sufficient.
Overuse of Multi-Manager Products
Direct diversification among investment managers may be more efficient for those with large portfolios, especially if nearing retirement. While these products give variety, they may lack customization, be more expensive, and demand diminished due diligence. Typically asset funds have multiple managers to ensure that respective asset class experts manage different categories.
Holding Assets You Don’t Understand
Private equity and non-public real estate are two non-publicly traded financial products that are advertised for their stability and diversification. However, due to sophisticated, non-standard valuation procedures, their hazards may be underestimated. Instead of daily market transactions, these alternative investments rely on estimates and appraisals. Don’t be fooled by modest correlations and standard deviations.
What are the Risks of Over-Diversification in Investments?
- When funds have similar holdings or strategies, diversification can be deceptive. Owning many large-cap funds, for example, may skew the portfolio towards that asset class.
- Over-diversification can dilute returns since the impact of individual investments becomes insignificant in comparison to the whole portfolio.
- Excessive diversification might create “index hugging,” in which the portfolio resembles a market index, yielding average or lower returns.
- Unanticipated trading costs, inefficiencies in taxes, and operating expenses can all undermine total portfolio performance.
- The main concern of over-diversification is that it reduces returns without reducing risk because each extra investment may not decrease the portfolio’s risk profile but it generally decreases projected returns.
- At some point, the benefit of risk reduction from each new investment becomes less than the drop in projected gains, making it less advantageous to make additional investments.
- Over-diversification can divert investors’ attention away from their most compelling ideas and result in an inordinate amount of effort spent monitoring many holdings, which can harm portfolio performance.
- Focusing on the most promising assets while weeding out the underperformers is a more effective technique than over-diversification.
Why Investors Over Diversify?
Diversification is a key investment idea that seeks to spread risk and maximise rewards. Over-diversification, or holding too many assets in a portfolio, can be detrimental. Several variables can cause investors to diversify their holdings excessively. This is why investors make this error, as well as how each of the following variables contributes to over-diversification:
Misunderstanding Risk
Over-diversification is mostly motivated by a misunderstanding of the concept of risk. The amount of assets in an investor’s portfolio is connected with risk. It is crucial to distinguish between diversifiable (or unsystematic) risk and non-diversifiable (systematic) risk. Diversifiable risk refers to asset-specific hazards, such as company-specific worries, that diversification can manage. Non-diversifiable risk is associated with broader market conditions and cannot be addressed by acquiring more assets. Excessive diversification to avoid diversifiable risk can be wasteful and expensive. When investors do not understand the assets in their portfolio, they may over-diversify.
Fear of Losing
Fear of losing money is a strong feeling that prompts investors to over-diversify. While this concern is understandable and justified, it might lead to poor financial decisions. Many investors are influenced by emotional bias and loss aversion. They may over-diversify to escape the psychological discomfort of seeing big losses in a concentrated position. This fear of losing money might keep investors from receiving the benefits of well-chosen, concentrated investments. Fear of financial loss can also cause herding behaviour. They jeopardise their portfolio’s long-term potential to avoid short-term losses.
Lack of a Clear Strategy
A lack of a clear investment plan is a major contributor to over-diversification. Investors may lack a clear plan, asset allocation strategy, or grasp of their financial objectives. Investors who lack specific investment objectives may disperse their investments among a wide range of assets, assuming that this scattergun method will shield them from all potential hazards. This lack of concentration can result in a portfolio that is neither efficient nor aligned with the investor’s financial objectives. This results in high transaction costs, frequent portfolio turnover, and a less coherent portfolio structure. Investors who do not have a clear plan are more prone to overreacting to news or market developments.
Influence of Market Hype
Investors sometimes make the mistake of spreading their money too thin across too many different things. This often happens because they get caught up in the excitement about certain investments, like a particular type of asset or industry. They worry about missing out on potential profits when they think something is going to be really successful.
In their excitement, investors might not take the time to thoroughly research the things they are investing in. This lack of careful research can lead to poor investment choices and the tendency to spread their money too thin, trying to deal with uncertainty.
How to Avoid Over-Diversification?
Over-diversification, a classic investment stumbling block, can dilute returns and complicate portfolio management. To avoid this, investors can use a variety of tactics to find the correct balance between risk management and performance optimisation. Here’s a detailed guide on avoiding over-diversification:
Set Clear Investment Goals
A well-managed portfolio is built on having defined investment goals. It entails determining your financial goals, risk tolerance, and time horizon. Setting specific investment objectives lays the groundwork for portfolio building and management. It assists you in matching your investments to your specific needs and tastes.
Monitor and Review Your Portfolio
It is critical to monitor and analyse your portfolio regularly to ensure that it remains aligned with your investing goals and the initial diversification plan. Schedule frequent assessments, such as quarterly or annual reviews, to analyse the performance of your portfolio and its connection with your goals. If market swings cause your asset allocation to stray from your original strategy, rebalance your portfolio by buying or selling assets to restore the appropriate composition. Evaluate your portfolio’s risk profile regularly. Make changes if your risk tolerance or financial goals change. Consider the tax consequences of portfolio adjustments, in taxable accounts. Look for strategies to reduce capital gains taxes. Examine your investing expenses and seek ways to save costs, such as moving to lower-fee funds or ETFs.
Seek Professional Advice
Seeking professional assistance can help you reduce risks and optimise your investing approach. Professionals can create investing plans that are tailored to your specific objectives, risk tolerance, and time horizon. Advisors can do extensive risk assessments and offer diversification strategies based on your risk tolerance. Advisors can assist you in navigating tax consequences and developing tax-efficient methods to maximise your returns.
How Money Panda can help in Portfolio Management?
Money Panad allows for diversification by providing access to pre-curated baskets of Mutual Funds. These baskets are diversified both at asset level ( small, mid and large cap ) and also at fund house level ( six different fund houses).
Conclusion
Over-diversification in an investing portfolio can be detrimental rather than beneficial, as it dilutes profits while not lowering risk. Several efforts can be taken by investors to prevent these hazards. To begin, they should establish specific investment objectives, such as risk tolerance and time horizon, to guide portfolio creation. Seeking expert counsel can also be beneficial, as financial advisors can provide specialised diversification strategies as well as assistance in navigating the difficulties of tax management. Money Panda can be a valuable resource for investors.
Frequently Asked Questions
- How does over-diversification affect the returns on a mutual fund investment?
Over-diversification can dilute the impact of good performers, lowering prospective returns on a mutual fund investment due to an excessive allocation across multiple holdings. - Is there an ideal number of holdings in a well-diversified mutual fund?
There is no one-size-fits-all recommended number of assets in a mutual fund portfolio, but 8-12 diverse mutual funds can provide appropriate diversification. - What’s the key takeaway regarding over-diversification in mutual funds?
The main point is that over-diversification can reduce returns and complicate portfolio management. To achieve peak performance, it is critical to find a balance. - How can I strike the right balance between diversification and concentration in my mutual fund portfolio?
Focus on 8-12 well-researched, diverse holdings in your mutual fund portfolio to balance diversification and concentration. Review and alter your portfolio based on your risk tolerance and investing objectives.
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