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“Portfolio diversification” as a concept sounds a lot like Soan Papdi to the investment community. It is transmitted from one person to another but is almost never consumed by anyone. The reason is not that people do not understand its meaning; on the contrary, they do not know the exact calculations behind it.
Diversification means spreading your investments across multiple instruments to minimize risk. But sometimes it is difficult to determine which combination of instruments achieves the result.
For example, if you buy shares in 10 different companies, you can minimize company-specific risk. But if these 10 stocks are in the same sector, you are exposing your portfolio to industry-specific risks. And precisely for this reason, there is no talk of optimal diversification.
This mostly happens when investors try to build a portfolio of mutual funds. We believe that diets with different names or different categories have different strategies, but this is not always the case.
Take the Axis Bluechip Fund and the Axis Flexi-Cap Fund, for example. The two funds belong to different fund categories, but they overlap by 92%. If you compare the portfolio holdings, you will find that both plans have 28 common shares. This means that adding both plans to your portfolio will not diversify your risk.
If you have too many mutual funds in your portfolio and want to modify them to avoid overlap, here’s how to do it:
Avoid buying too many Schemes from the same category
It doesn’t make sense to buy multiple plans in the same category, especially with large-cap funds. Under SEBI regulations, a large-cap fund must invest at least 80% of its assets in large-cap companies that rank from 1 to 100 in terms of market capitalization on Indian stock exchanges. On the other hand, when you look at indices like the Nifty 50 and the BSE 100, the composition is mostly similar, making it difficult for a major regime to outperform the index. Also, because the investment pool in a large-cap program is so small, there is almost no opportunity for a fund manager to pursue a different strategy.
Check the cartography of the sector
Compare your mutual funds and determine your exposure to different sectors. If you find that two or more funds in your portfolio have similar sector allocations, or if the net sector allocation is too high, you should reconsider your investment weighting.
Avoid adding multiple funds managed by the same fund manager
Although required, it is ideal for diversifying your portfolio at both the fund manager and CMA levels. This is because funds managed by a single manager are likely to share a common investment strategy, as their views on sectors and stocks will also differ depending on the type of fund they manage. Some similarity can also be found at the AMC level due to a joint research team. So ideally you should limit your exposure to a fund manager or AMC to 30-40%.
It is true that diversification helps you mitigate risk, but only up to a certain number of supplements. If you invest in too many plans, you will probably invest in the same stocks. If the underlying stocks are different, you may end up owning the entire market, making it difficult to generate alpha. The correct diversification approach is to have 3-4 funds with different investment strategies in the correct proportion.