In today's uncertain markets, diversification is key to achieving investment success. It is proven that diversification not only reduces risk in your portfolio, but also allows it to perform under different market conditions. Broadly speaking, you could achieve portfolio diversification (read: asset allocation) by investing in different asset classes, such as equities, debt and gold. But, still greater diversification could be achieved by investing in different securities within an asset class.
Mutual funds have emerged as an ideal option for investors to achieve diversification. Apart from being a diversified investment vehicle, these offer a variety of funds within an asset class. For example, for the equity portion of your portfolio, you have the option to choose from a variety of funds, such as large-cap, mid-cap, small-cap, multi-cap, index, sector, thematic, contra and opportunity funds.
If you choose well, both in terms of type and number of funds, you can not only restrict the impact of volatility in your portfolio, but also get better returns over time. Unfortunately, diversification is also an aspect of portfolio-building where a number of investors err. The common belief is more the number of funds one invests in, the more diversified the portfolio. It is a myth that investors have been believing in for years.
Even while investing through systematic investment plans (SIPs), many invest in a number of funds. One often comes across portfolios where an amount as low as Rs 5,000 is invested through SIPs in five funds. If your portfolio suffers from over-diversification, it would dilute your returns over time, as non-performing funds pull down overall returns. Moreover, having too many over-lapping funds would invariably make your portfolio quite complicated.
It is always difficult to keep track of a complicated portfolio. On the other hand, a few carefully selected funds in the portfolio could provide you with a higher level of diversification and that too, without compromising on your returns.
Over-diversification can harm your portfolio in some other ways, too. For example, a quality mid-cap fund is a must for a long-term portfolio, as it can help improve the overall portfolio returns. However, having too many mid-cap funds in your portfolio for the sake of higher diversification would invariably make you compromise on the quality of the portfolio, as stock picking and a sound investment process are major differentiators for these funds.
Considering the mid-cap segment suffers from poor liquidity and limited coverage, it is always prudent to opt for a quality mid-cap fund that has an established performance track record.
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