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How do investors get diversification wrong?

Ultimately, you want a good balance of risk and return from your attempts at a diversified portfolio rather than having a bit of everything. You will know you’re heading in the wrong direction if you’re doing any of the following.

The advantages of having a diversified portfolio are greatly spoken about. For individual investors with no ability to analyse the many nuances of financial products, diversification is a good way to minimise risk. However, there is one thing that you must beware of and that’s – over-diversification. 

Ultimately, you want a good balance of risk and return from your attempts at a diversified portfolio rather than having a bit of everything. You will know you’re heading in the wrong direction if you’re doing any of the following.

1. Adding too many different products

This can happen if you start allocating to a different product for each goal. A pension product for retirement, a mutual fund for education, a house for your child’s wedding gift, fixed deposits, PPF, shares, gold and so on. While each type of product might have a different goal, the purpose may not be different.

You may end up with three different financial products, with different risk and return features but with the same long-term objective. It is perhaps more suitable to consolidate goals and identify the investment horizon, then choose financial products to help you achieve the most optimum risk return balance. 

For example, for all long-term requirements of more than 10 years investing in PPF will not be as effective as investing in equity; provided you already have an allocation for stable fixed income investments, adding PPF only reduces the expected long-term return. You will have better control of risk too with fewer products in the mix. You don’t have to own every type of investment in the garb of diversification. 

Over-diversification within the asset class is also not useful. What this means is that adding too many shares, too many funds, or too many properties for that matter, does not translate to better risk management or better returns. 

2. Over-diversifying in one asset

Over-diversification within the asset class is also not useful. What this means is that adding too many shares, too many funds, or too many properties for that matter, does not translate to better risk management or better returns. 

In fact, it can mean that you don’t earn your desired or expected return from the asset class. In case of real estate for example, adding too many properties, also adds to cost; there is cost of loan, registration costs, municipality costs, property maintenance and so on.

Plus, if you have diversified across locations, chances are some locations will work positively for price rise and others may remain below average. Real estate is not an easy asset to sell, which will leave you with higher risk rather than lower.

With financial investments like mutual funds and stocks, having too many will only give you overlaps and reduce your potential return. You will end up investing too little in each fund and hence, returns too will not look substantial.

Like with real estate, the danger with choosing too many is that while some will do well, those which don’t perform above average will bring down your overall return.

Diversification is useful for mitigating excessive risk of holding just one type of security or asset. However, achieving that perfect balance of assets and investment products is also not easy. 

As a thumb rule stop adding the next investment if the return you make does not add to your overall portfolio return or it doesn’t reduce risk. If the risk of adding that product is more than the risk in your existing portfolio of investments, you might make a higher return, but you have put capital at greater risk.

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