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What is diversification and over-diversification of Mutual Funds?

The most common metaphor for diversification is not having all your eggs in one basket. The portfolio theory definition of it is slightly different.

This came to us as a question from a Scripbox member.

Q: Would be very helpful if you could help me understand what is diversification and overdiversification of Mutual funds. When does diversification becomes over diversification? Are there any advantages/disadvantages, etc. ?

A: This is a great question because diversification is a term from portfolio theory which is not completely understood by investors. The most common metaphor for diversification is not having all your eggs in one basket. The portfolio theory definition of it is slightly different.

Let’s say a farmer has a 100 eggs to take to the market. He puts them into 4 baskets - 25 each. If he drops a basket, he only loses 25 instead of all 100. This is managing a type of risk called concentration risk. The more baskets he can put my eggs into, the better it is. Of course, there is the added cost of having to buy many baskets! Which may become more than the cost of eggs that he is protecting.

Similarly, If I put all of my money into one single mutual fund, I also face concentration risk. I can reduce this by putting my money into 2-4 similar mutual funds.

If multiple baskets is reducing concentration risk, what is diversification?

Diversification is about achieving a preferred risk/return objective by constructing a portfolio of non-correlated investments.

In plain English, a diversified portfolio is where 

1. you combine more than one investment category

2. the return and risk characteristics of your chosen investment categories are different (non-correlated). 

3. the sum total of return and risk matches what you want to achieve/ are okay with.

This is done by choosing the right mix of asset classes (asset allocation).

For example: You would diversify your mutual fund portfolio by investing in both Equity funds and Debt funds. They each have different return expectations and price volatility. By holding, say, 40% of your investments in debt funds you can reduce the overall risk (volatility) of your portfolio.

You could also diversify within Equity by allocating your money across Large cap, Mid cap, Small cap etc. The correlation here would be higher than that with Debt.

Within large cap, you would pick stocks from different sectors (non-correlated) to create a diversified large cap portfolio.

Investment managers construct sophisticated models and track the risk/return characteristics of asset classes and securities (stocks and bonds) to construct their portfolios.

In plain English, a diversified portfolio is where you combine more than one investment category and the return and risk characteristics of your chosen investment categories are different. This is done by choosing the right mix of asset classes (asset allocation).

Your job vs fund manager’s job

At this time it is also apt to understand the difference between what you should focus on and what your fund manager does. 

As a consumer, your job is to decide on the appropriate asset allocation for your investment objectives and thereafter pick the mutual funds that map to your chosen asset allocation.

A fund manager’s job is to create a diversified portfolio of stocks that deliver the objective of the fund. So if it is a Large Cap fund, the fund manager must pick a diversified portfolio of large cap stocks that achieve the optimum balance of risk and return.

While diversifying, should I worry about the stocks a mutual fund is holding?

Yes and No.

Yes, to the extent the objective of the fund matches your asset allocation. This has become easier after July 2018. A mutual fund must identify itself as belonging to one of the 36 categories by objective and then must stick to it. So all you need to do is to pick the asset class of fund.

No, because the actual stocks held should be left to the discretion of the fund manager. Their performance track record would reflect whether their strategies are successful or not.

Over-diversification

Mostly I would describe this as buying too many funds  without actually diversifying hoping many baskets are better. 

When you are making a conscious choice of asset classes to diversify, investing in too many asset classes relative to the size of your portfolio would be over diversification. A Rs one crore portfolio may need five to six asset classes but a Rs one lakh portfolio may be OK with just two. 

Important notes:

a. Most investments have some degree of correlation. So the idea is to seek out investments with higher non-correlation

b. Diversification DOES NOT increase returns. Indeed it reduces returns as at any given time, some of your investments are moving one way and some are moving the other way.

The baskets of eggs analogy extended to diversification

This would require that all the baskets are not the same or are being transported differently. 

Let’s consider that the farmer was transporting some baskets by truck and the others on a bike (with his nephew holding the baskets on the rear seat). With this, the probability of the baskets dropping is different depending on the mode of transport. The farmer now has to decide where he should put his eggs. Carrying them by bike is cheaper but riskier while transporting them by truck is more expensive but safer. 

The farmer can choose to transport some baskets by truck and the others by bike. This reduces his overall risk due to diversification among the modes of transport. And the reduction in cost would increase his profit.

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