Diversification is good but over-diversification is dangerous for your stocks portfolio. There is a famous saying that one should not put all his eggs in one basket, which is quite relevant in the stock market. Investing all capital in few stocks only could be disastrous. One should always diversify his portfolio and include different stocks so that underperformance of any stock could get countered with the outperformance of other stocks. The excess of anything is also bad and this is true in the case of the diversified portfolio as well. One should definitely diversify his portfolio but it should never be over-diversified.
Every portfolio manager advises diversifying the portfolio as it lead to profitable investment in stocks and I also agree with that. We need to understand the extent up to which the portfolio could be diversified so that it doesn’t get over diversified. A well-diversified portfolio helps to generate wealth but an over-diversified stocks portfolio can destroy the wealth.
What is diversification of portfolio ?
Diversification simply means you include stocks from different growing sectors in your portfolio. An ideal diversified portfolio can have 10-15 stocks from various sectors. But some people adds 30-40 or even more stocks in their portfolio. This inclusion of too many stocks leads to the over-diversified portfolio. Let’s understand the difference between diversified and over-diversified portfolio with the portfolio of Mr. Ramesh and Mr. Suresh
DLF, HDIL, Unitech, Bharti Airtel, Reliance communication, SBI, PNB, Syndicate bank , ICICI Bank , Axis Bank, Britannia , HUL, Emami, Tata motors, M&M, Bajaj Auto , Hero Moto corp, HCL Tech, Infosys, TCS, BHEL, L&T , Ambuja Cement, Ultratech, Cipla , Sunpharma
Total 27 Stocks
DLF, Bharti Airtel, SBI, Axis Bank, HUL, M&M, TCS, L&T, Ultratech , Lupin , Tata Steel
Total 11 stocks
Ramesh Portfolio has 27 stocks from reality, telecom, banking, FMCG, Auto, IT, Capital goods, Cement and Pharma. Total he has 27 stocks from 9 different sectors. While Suresh has 11 stocks from 10 different sectors. So Suresh has diversified his portfolio better with 11 stocks only.
Let’s assume economic slowdown comes and Auto, reality, and banking sectors get badly affected. Then Ramesh portfolio will be affected more as he has 12 stocks with those sectors but Suresh portfolio will be less affected as he has only a few stocks from those sectors. Even in severe bear market some sectors like IT, Pharma and FMCG continues to perform well. Ramesh has included more stocks from same sectors and his portfolio will be more affected than Suresh portfolio.
So you can observe yourself over diversifying the portfolio doesn’t give any benefit and a nicely diversified portfolio with even fewer stocks can do well. One should always avoid including more than two stocks from the same sector in the long term portfolio. I prefer just one.
Why should you not include too many stocks in the portfolio ?
When you have too many stocks its becomes difficult to keep track of those stocks. You have to keep track of the things like quarterly results, related news, management issues, the performance of company etc. You have to spend a lot of time in tracking these things for different stocks. Even if you are following any expert then also it will be difficult to manage many stocks.
Another major problem of having too many stocks in the portfolio is that it leads to negative returns many times when many sectors do not perform . The number of high-quality sectors and stocks is always less than the poor quality sectors and stocks. Out of 5,000 listed companies in India less than 0.5% stocks generate 100%+ annualized return(multi-bagger) ,5%-10% stocks generate 20%+ annualized return,another 10%-15% generate 10%+ return, the rest 70-75% stocks either remain flat or generate negative return. When we include too many stocks we include a lot of bad stocks in the portfolio. The negative or flat return from such stocks minimizes the overall returns from the portfolio.
Diversification is good but over diversified stocks portfolio is never good. Always try to have minimum stocks from best sectors in your portfolio. Never included more than 2 stocks from any sector. Famous investors have always kept their portfolio small. Warren Buffet always preferred to keep 10-15 stocks in his portfolio. Rakesh Jhunjhunwala portfolio is also restricted to 10-12 stocks at a time.
Benjamin Graham views of diversification are
There should be adequate though not excessive diversification. This might mean a minimum of 10 and maximum of about 30
While Warren Buffet says
The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great as few as ten to fifteen different holdings usually suffice
He uses the 20 punches mental model to pick the number of stocks in his portfolio. In his letters to shareholders, he says
I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had 20 punches representing all the investments that you got to make in a lifetime.
And once you’d punched through the card you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.
The problem with most of us investors is that, too often we scatter money around while saying to ourselves Okay let me throw a little money in this stock and little in that stock and then see what happens. At least one of the stocks will work
Now that’s a sure shot road to a hell lot of risk first you don’t know where you are scattering your money and then you think you are investing while the reality is that you are speculating in the hope of hitting the right stock
That means if you are having shares of too many companies you are speculating more and investing less. Diversification may preserve wealth but concentration builds wealth. To more about Warren Buffet concentrated portfolio strategy I suggest you to read the book Warren Buffet Portfolio
Peter Lynch says
Owning stocks is like having children, don’t get involved with more than you can handle
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.