Over diversification means Lower Returns: How?

Investment

oi-Sunil

By Sunil Fernandes

Published: Tuesday, November 5, 2013, 8:37 [IST]

Diversification of investment means selecting multiple asset classes or investing in the different asset categories. It is a popular technique employed by most investors to lower risk and increase the chances of good returns. Unfolding your investment in different areas develops a risk-proof portfolio, which means if one investment fails, another will balance it out.

How to design a diversification strategy?

Having a diversified portfolio helps palliate risks. However, investors usually wonder the quantity of diversification rather than quality. Too less or excessive diversification may not provide the most coveted outcome. You have to design a balanced and wise diversification plan for better returns.

Why diversification is a must?

Firstly, diversification lowers risk. Secondly, the returns of different asset classes differ in different phase of life. The investment in one asset class fetched negative returns this year, but other investments have performed exceptionally well in the market. This has balanced your loss/risk. For better understanding, stated below is an illustration:
Mr. X invested in gold and it has performed wonderfully until last year. However, in the current year it has brought in negative numbers. But his investment in stocks has worked in your favor and brought in superlative return.

The above example shows how Mr. X earned handsomely well, despite losing upon one asset. Therefore, diversification is needed.

How should investors diversify stocks?

Diversification in shares or stocks can be easily achieved by purchasing stocks from different sectors. However, it is important to select sectors that are not related. This way a fall in one sector may not affect other sector much. For instance, an investment in Infrastructure stocks will not have a direct effect on your investment in Pharmacy stocks. However, it is significant not to diversify too much because over diversification creates problem in managing and tracking your portfolio.

How investing in different asset categories helps investors?

Investment in different asset classes like:
Bond - brings in assured income i.e. gives assurance of ‘fixed' income.
Stock /equity funds- helps in successful growth of your investment portfolio.
Liquid investment - Bank FDs and liquid assets guarantee the liquidity.
Income funds - guarantees income stability.

What are the advantages of a diversified portfolio?

Diversified portfolio pronounces several benefits to the investors. Revealed below are a few:
It helps to multiply returns.
Money diversification means risk diversification. It helps to limit investment risks.
It helps in increasing liquidity rate in your portfolio.
At times, single investment results in higher risk and lower returns. Diversified portfolio generally assures desired results.

What are the Risks even after Portfolio Diversification?

Diversified portfolio has certain built-in risks. For example, stocks could be fickle in the short term.
Even though you have carefully diversified your portfolio, there is always a percent chance of investors undergoing losses due to emergency conditions. Some of these factors include commodities meltdown, global financial crises, socio-political condition and others.

What are the dangers of over-diversification?

Over-diversification creates problem in maintaining and managing investments. Too many stocks in a portfolio may not give a significant value to your investments. Also, it becomes difficult to keep track of various investments.

Another problem with over-diversification, it generally leads to increase in transaction costs like bank charges, fund manager fee, DP charges and so on.

Over diversification will dilute the returns. Instead of limiting your investments in a few best investment options, you will tend to diversify in more investment options. As a result you will be investing in best and average investment options also. This will dilute the return.

What are the perils of too less diversification?

If you do not diversify your portfolio, your risk of losing too much on assets will increase. Also, less diversification will lead to high risk.

The main goal behind portfolio diversification is risk diversification, earn a decent return in a reasonable time frame with less volatility fulfill the planned financial objectives. In order to diversify your portfolio in a customized way, you must have a comprehensively created financial plan to achieve your aims.

K. Ramalingam is the chief financial planner at holisticinvestment.in, a leading financial planning and wealth management company.