September 21, 2012

Is over diversification impacting your portfolio?

It is well known fact that diversification is a “mantra” used to reduce your portfolio risk. But sometimes it happen such that, without your notice you expose to over diversification. This over diversification may harm you in other way than what you risk of being non diversifying.

To understand my sayings in a better way, it is important to first understand risk classifications. Basically their are two types of risk. First one is “Systematic Risk” which is also called non-diversifying risk. Means in whatever way you diversify your portfolio such type of systematic risk are always be their. Second type of risk is “Unsystematic Risk”. Such type of risk always associated with specific sector or stock. This can be easily eliminated with diversifying your portfolio.

Now the question is, how much diversification is good? Their are so many theories around the world like Evans and Archer theory (1968) where they showed that maximum diversification can be achieved by investing around 10 to 12 stocks. Contradicting to this Meir Statman (1987) observed that around 30 stocks need to well diversify portfolio. In Indian stock market view study was conducted in 90s and found that around 70 to 75 stocks are a good diversification but again in 2007  the study conducted on Indian market showed that what Evans and Archer theory is exactly matches with Indian market (different in results may be due to time factor and may be now Indian Stock Market is equally efficient with  global). According to modern portfolio theory, you can achieve diversification by around 20 stocks. Let us understand this theory in a better way with below image.

From the above image you noticed that to the certain extent you can get benefit of diversification but after that the effect is minimal. But above theory does not specify that by merely buying any 20 stocks you will diversify in a better way. You need to select in such a way that each stock or investment have uncorrelated with each other like different company size, industry, sector and country.

So it is mis-conception that choosing so many stocks or mutual funds will really diversify your portfolio. For example if one have investing amount around Rs.10,000 monthly and person chooses around 15 to 20 funds will not a true diversification. Hence it is always better to look for the goal and risk you have and the sector you are choosing. Over diversification may cause in increase of your expense ratio too. But it does not mean that you loose too much by over diversification instead you also not gain too much.

 

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