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It is essential for every investor to understand what over-diversification looks like so that they can avoid falling into that trap themselves. (Representative Image)

Diversifying investments is essential to minimise risks and ensure steady returns. It is, no doubt, an advisable strategy that should be implemented as you build your investment portfolio to have a better risk-adjusted returns in the long run. With investments spread across asset classes and various instruments, you not only get a balanced portfolio but also don’t miss out on asset-specific performance during the different phases of the investment horizon. However, when there is too much diversification, the entire objective of diversification is defeated. Neither do you get optimum returns on your investments, nor are your financial goals met as planned.

The old proverb “excess of everything is bad” is true with your investment as well. If you over-diversify your investments, it actually starts hurting you. Investment experts call it ‘diworsification’; which essentially means your excess diversification is having a worsening impact on your investments. What is sad about over-diversification is that most investors do not realise it. They continue to have the notion that their diversified investment portfolio is the most suitable way to invest. Therefore, it is in investors’ best interest to understand what over-diversification is and when to take corrective actions to keep their wealth creation journey intact.

What is over-diversification?

Over-diversification is when you spread out your investments far too much across instruments or fund types or sectors with a view to balance out your returns. Within limits, this is very helpful as it balances out the ups and downs of the market and helps you ensure better risk-adjusted and steady returns. However, if you spread yourself too thin, then you stand to lose out on the benefits of diversification.

It is not that investors lose out too much because of over-diversification, but they do not gain much either. Further, an over-diversified investment portfolio actually increases the risk of losing out on returns as all asset classes don’t underperform or outperform at the same time. Their growth cycles are different, which calls for strategic diversification to reap the most benefits.

For example, assume an investor has invested Rs 1 lakh in an over-diversified portfolio of 10 equity mutual schemes: Rs. 10,000 each in mid-cap, small-cap, large-cap, sectoral funds like pharma, banking, IT, and infrastructure, among others. If three of them generated an average return of 80 percent over the last year while the rest seven offered a return of 10%; you end up investing a mere 30 percent of your total investments in the top-performing schemes while a bigger chunk of your money continues to earn a relatively dull return. What is more damaging is the fact that poor return on larger investment pulls down your overall return to about 31 percent. This essentially means that you do not need to be investing everywhere at every given point in time.

It is essential for every investor to understand what over-diversification looks like so that they can avoid falling into that trap themselves. So, here are some indicators that can help you understand if your diversification strategy is just right or if it needs to be tweaked.

Five signs 

1). Confusion and Obscurity: The first sign of over-diversification is confusion and lack of clarity about your investment portfolio as there are too many investments going on at the same time. It generally comes from the fact that you are unable to keep track of your investments and hence are finding it difficult to know what’s going on with the invested money. In other words, you don’t understand your holding assets.

2). Various investment instruments concentrated in a particular asset class: If your investments are concentrated in, say, equity; through several instruments, prima facie, it may look like concentration, not diversification. But actually, it could be yet another sign of over-diversification. An investor may have investments in equity mutual funds as well as direct equities. Further, they may have several equity schemes — midcap, smallcap, largecap, flexicap — and at the same time, may have investments in more than two dozen stocks. Such a concentration of investment instruments in a specific asset class is a clear indication that the investor is excessively diversified. Similarly, if you have too many fixed deposits or recurring deposits in your portfolio, it also means over-diversification.

3). Having multi-asset investments at every point in time: If you have an investment in every asset class throughout the investment tenor, it signals over-diversification. It is worth mentioning that there are times when one needs to cut down investments from an underperforming asset to an outperforming asset. Upon failing to do so the growth trajectory of returns remains sub-optimal.

4). Similar mutual fund schemes in portfolio: If the majority of mutual fund schemes in your portfolio are similar in nature, you have unnecessarily over-diversified. For instance, if there are several small-cap or mid-cap, or large-cap schemes from different investment firms, it is a sign of excessive diversification.

5). Owning too many individual stocks: Ideally, holding 15-20 individual stocks is adequate enough to offer you the benefits of diversification. If you go beyond this threshold, you might actually be over-diversifying, which would not be healthy for your investments.

Diversification is key and should be followed for stable and steady returns in the long run. However, excessive diversification takes away the advantages of a well-diversified portfolio. You should review your portfolio from time to time, and it is worth consulting your financial advisor in case you feel the need for some expert advice. It is a fine line between diversifying and over-diversifying, and maintaining that distinction can make or break your financial goals.