Over diversification in investing tends to reduce returns: Here's why
Investing in too many products, whether in stocks or MFs, shows the investor is not thinking hard enough.
Recently, I had the opportunity to look at some data of a number of real world stock and mutual portfolios that a large sample of Indian investors have. The numbers were eye-openers. An overwhelming number of these portfolios were much larger than they should have been and some were huge.
It’s surprising that so many investors have portfolios that are such far outliers in terms of size. In the sample I studied, more than half the portfolios (of ones invested in stocks) had more than 50 stocks, with about 10% going to a 100 and beyond. This is a shocking number and I use the word ‘shocking’ with due consideration.
Fifty to 100 or even more stocks would be quite a large portfolio even for a mutual fund and funds have professional fund managers and research staff. At Value Research, our premium Stock Advisor service has a list of 38 recommended stocks and not only do we have a team of analysts, they have extensive data support from the rest of the organisation as well.
For an individual to invest in these many stocks implies that the invested list is not based on enough work. Even a brief study of the stocks confirms this. By and large, most investments are recent, meaning these are short-term portfolios. Moreover, the actual stocks chosen are essentially momentum stocks. Most investors are concentrated in small-cap and smaller mid-cap stocks that have started moving in recent weeks without any clear reason for them to start making gains. Even larger stocks belong to the same category.
Some of the portfolios have long-term holdings of quality stocks but in terms of weightage, these are generally dominated by momentum stocks. It’s clear that not only do people invest in a lot of stocks, they invest with little thought. This is implicit in the numbers.
So how many stocks should one invest in? The answer to that question is not a number. It depends entirely on an individual investor’s capacity to understand and analyse investments. If an investor does not understand the logic and rationale for a particular investment, then that investment should be avoided. This number could be two or three or 10, but it’s unlikely to be 50.
The bottomline is not the number but one’s bandwidth. Even the greatest of investors, Berkshire Hathaway’s Warren Buffett and Charlie Munger, who have access to any research resource money can buy, refused to touch tech stocks for decades.
That is because they felt they did not understand technology. Not that they couldn’t hire anyone in the world who did. They avoided tech because they felt that they personally did not understand it well enough. That may sound like an extreme view to some, but should actually be normal behaviour for investors. Sure, you can—and must—extend the circle of your knowledge by using tools and services, but these are just your tools, and nothing more than that.
If, as a budding stock investor, you feel that the time and effort required is a bit too much, then the obvious solution is mutual funds because that’s what mutual funds are for. Of course, the problem with which I started—too many investments—is just as commonly found among mutual fund investors also. However, in mutual funds, I can give you an ideal number and its logic.
Some years ago, we also did a detailed simulation of investing in different number of funds over different time periods. The ideal number, both practically and theoretically, has always turned out to be four or five. That provides the best balance between diversification and management overhead.
Not just that, depending on how you choose your funds, it also has the potential of offering the highest returns. Once you go much beyond that, say seveneight funds and more, your returns are going to be closer and closer to the average and/or to the benchmark. If that’s what you are going to get, then you might as well choose one, single low-cost ETF or index fund and be rid of the whole headache.
No matter which way you look at it, a modest number of investments that an investor understands well is the only way to go.
(The writer is CEO, Value Research)