Is Your Mutual Fund Portfolio Over-diversified?| North Loop Official Blog
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23 Oct 2020

Is Your Mutual Fund Portfolio Over-diversified?

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Introduction -

You surely have heard about the numerable benefits of portfolio diversification and the importance of spreading out your risks. But do you know what makes your mutual fund portfolio over-diversified? What are the ways by which you can identify an over-diversified portfolio? And what are the drawbacks of an over-diversified portfolio? If you don’t, then fret not. We have covered all of the above topics in this article. But before we begin, let us clearly understand what portfolio diversification means and why should you diversify your portfolio in the first place.

What do you mean by portfolio diversification?

Portfolio diversification is a risk management strategy that involves adding a variety of mutual funds into your portfolio which invests in different asset classes. This strategy primarily helps in reducing the overall investment risk by spreading out your investments across multiple assets with varying risk levels.

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Why should you diversify your portfolio?

The reasons for diversifying your portfolio are as follows -

Spread your risks - Portfolio diversification helps to spread your investment risk across multiple investments so that adverse movement in any one segment of your investment does not negatively impact your overall portfolio returns.

Maximise returns - The ultimate purpose of portfolio diversification is to ensure that you get stable returns during varying periods. That means, even when a particular asset class is experiencing low levels and providing low returns, a diversified portfolio can help you in receiving stable returns from the other asset classes present in it. That way, you can record returns without worrying about any particular asset class.

Balance equity and debt - Since both equity and debt have different risk values, diversifying your portfolio by including a balanced mix of both can help you get moderate returns even during market volatility. It can balance the shortcomings of one with the advantages offered by the other.

What are the ways by which you can identify an over-diversified portfolio?

Several mutual funds within a single category - As we have established above, the purpose of diversification is to invest in different types of funds such that the overall investment risk gets mitigated. Therefore, if you invest in multiple funds of the same category, then it can become difficult to get numerous sources of returns and also reduce the overall risks. Therefore, investing in too many mutual funds within the same category is a classic example of an over-diversified mutual fund portfolio.

Impact by single events - If one macro-economic development has a disproportionate impact on your overall mutual fund investments, it can be a critical indicator of an over-diversified mutual fund portfolio.

What are the drawbacks of an over-diversified portfolio?

Multiple tracking - An over-diversified portfolio means having too many funds of different categories and asset classes. That ultimately leads to difficulty tracking each of them individually.

Cost burden - Over-diversifying can give rise to a cost burden in terms of extra brokerage fees, expense ratio, management fees etc.

Things to consider when building a diversified mutual fund portfolio -

There is no correct number of funds that you can invest in for a perfect diversified mutual fund portfolio. The only way to reach a nearly perfect portfolio is by doing consistent research about the various funds, their past performances and aligning them with your investment goals and risk profile. Few other factors that you can consider when building a diversified mutual fund portfolio are as follows -

Determine category, theme and strategy of your funds - One of the ways to diversify your portfolio is by spreading it across various asset classes (Debt/equity/hybrid), themes and strategies (dynamic/arbitrage) etc.

No more than 3-4 funds within each category - An exceptionally high exposure to any one segment is not too favourable for a mutual fund portfolio. Therefore, most experts do not recommend buying more than 3-4 funds within each category for those building a well-diversified portfolio.

Conclusion -

The most important thing to remember is that over-diversification may not make you lose much, but it also does not help you gain any better. In fact, in most cases, an over-diversified portfolio leads to higher expenses and an added burden of maintaining, managing and monitoring them over time. Therefore, even though diversification is crucial, it should only get done after proper research and analysis. A smaller and simpler portfolio can sometimes be better than a large mismanaged one.

You can track the performance of various mutual funds and invest in them online via North Loop. We offer a digital investment platform to help you invest in mutual funds from the comfort of your home and with the utmost ease. You can also use the help of our professional mutual fund advisors to choose funds that best suit your needs. To start investing, sign up now.

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This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended be advice. You must obtain professional advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax, investment or other professional advice from North Loop or its affiliates. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. All opinions expressed do not reflect the views of North Loop nor are endorsed by North Loop.