How Can Over-Diversification In Mutual Funds Work Against You?

Diversification is a strategy adopted by most of the mutual fund investors. Essentially, diversification means spreading your mutual fund investments across more than one avenue, to offset the loss of one investment with another. It means, if one investment falters, it is offset by another.

Though diversification is imperative to mitigate risks, over-diversification can go against you. But no matter, how widely you have diversified your investment, you can’t ignore the risks completely. So, don’t hoard investments blindly in the hope that it will help you overcome market volatility. At times, too much diversification of mutual fund investment can yield undesirable results.

1. Low Impact

If you have too many funds in your mutual fund investment, your profitable investments will not generate enough corpus for you. As your money is thinly spread across different investment options, the impact of a healthy upside in one fund will be minimum. Therefore, when you over-diversify your investments, you fail to make the maximum out of the investment option.
Suppose your mutual fund investment portfolio has 30 funds, a 10% rise in one fund will marginally affect the performance of your portfolio. For any investment to leave a high positive impact on your returns, it is necessary that it should form a reasonable part of your portfolio.

2. Tough to Manage the Portfolio

It is daunting to keep a tab on the huge portfolio and track various mutual investment options. If you fail to monitor your investment regularly, you will lose the opportunity to gain from market upside. Moreover, it will also make it difficult to notice low performing funds. You may realise this late by the time; the asset value could have already fallen substantially.

Further, too much diversification can lead to increase in the transaction costs, like brokerage charges, etc.

3. Overlapping of Benefits

Equity funds include stocks with the holdings spread across different companies. However, many times, investors often make the mistake of buying funds, each has at least 50-60 stocks. However, due to over-diversification, they end up paying more for the same set of funds. As a result, there is duplication in their mutual fund investments which, unfortunately, doesn’t add any value to their portfolio. It is simply an overlapping of investments.  Further, these funds behave in the same manner when the market moves.

So, What Should Be the Right Size For A Portfolio?

As said by Warren Buffett, “Wide diversification is only required when investors do not understand what they are doing.”

The extent of diversification depends on the investor’s risk appetite, returns and understanding of the market. According to experts, 4-5 diversified equity funds with mid-cap and large-cap stocks are enough.

In case, you have a clumsy portfolio; it’s time to alter it and bring it back into shape. A nip here and tuck there can systematically align your investments. However, stay away from getting rid of your mutual fund’s holdings blindly. The following points can help you balance your investment portfolio:\

1. Stick to profitable investments for some time

Many times, it has been seen that to rebalance their investments, investors sell off their winning stocks. However, it is essential to stay with profitable investments for some time. In order to rejig your portfolio, curtail those portions where the exposure is minimum, i.e., low-value stocks. It will not only help in reducing the number of stocks but will also make your portfolio balanced.

2. Get rid of similar investment options

To balance the portfolio, it is necessary to identify and remove those mutual funds that are similar to other current holdings in the portfolio.

3. Check costs carefully

When you cut down your investment portfolio, there are some costs which you also need to incur. Every time, you sell units of a mutual fund, you would have to pay a transaction cost as well. Further, you must be aware of the possible taxes and exit loads at the time of offloading your investments. It is necessary to stay invested for a considerable period, not only to avoid costs, but also to enjoy long-term returns.

The Bottom Line

Ideally, a portfolio should be sufficiently balanced so that if one asset suffers, the impact can be offset by the other. As it is true with other things in the world, simplicity is the best virtue in the world of financial planning as well.