There is a myth that investing in many mutual funds simultaneously, hoping for better returns, is a good strategy. In fact, many investors deliberately turn their portfolios into a crowded, confused collection of schemes that hold nearly the same stocks, use similar investment methods and strategies and deliver nearly identical returns.
The result of such decision-making investing is: more complexity, more doubt, less clarity and little real diversification. The biggest problem in following such investment strategies is that they are seldom backed by professional guidance and are mostly driven by emotions.
What is over-diversification?
Over-diversification occurs when investors continue to add new mutual funds, stocks or asset classes to their portfolios, in the name of reducing risk and managing economic volatility.
This investing behaviour results in individuals owning multiple schemes, with overlapping or similar portfolios. Furthermore, when practised purposefully, such a method can result in excessive fund holdings, dilute performance, destabilise the entire portfolio and make comprehensive portfolio management and analysis very difficult.
For example, having 12-15 very good stocks in your portfolio can be a reasonable idea. Whereas, having 50 or 70 stocks can be a clear case of over-diversification in equities. Similarly, having three to four good mutual funds is a reasonable goal, but aiming for 12-15 is not.
Important signs of over-diversification
|
Signs of over-diversification |
Why it matters |
|---|---|
| More than 10-12 mutual funds | Harder to track and review |
| Multiple funds in the same category | High portfolio overlap |
| Similar fund managers or strategies | Limited diversification benefit |
| Frequent new fund additions | Creates clutter and confusion |
| Unsure why you own a fund | Indicates a lack of portfolio purpose |
5 simple ways to fix over-diversification and boost returns
1. Start with asset allocation, not fund selection
Make sure you decide how much to allocate across asset classes, such as equities, debt, gold, mutual funds and international assets, based on your economic objectives and risk tolerance. Asset allocation helps in boosting portfolios, driving long-term returns far more than the number of funds you own.
2. Eliminate overlapping funds
Holding three large-cap mutual funds rarely offers three times the diversification. You should compare portfolios and remove schemes that invest in largely the same stocks. It is not a prudent idea to invest in similar stocks or mutual funds. The focus should be on proper diversification across asset classes to effectively manage overall portfolio risk.
3. Give every fund a clear role
Every fund or scheme you opt to invest in should be done with a specific objective in mind. Focus areas should be core growth, child education planning, stability, tax savings, health planning, income generation or global exposure, etc. If a fund has not been given a defined role, consider its place and prominence in your portfolio.
4. Consolidate around quality, not quantity
The focus should be to consolidate your investment portfolio around quality, not quantity. A well-thought-out portfolio can help in accomplishing its objectives with just five to eight diligently selected funds. Fewer funds make monitoring easier and improve decision-making. For example, instead of going ahead with three to four similar funds, you can look to invest in different kinds of funds, such as large-, mid- or small-cap, to boost your portfolio.
5. Review and rebalance regularly
Market movements can distort your intended allocation over time. Review your portfolio annually, understand limitations and rebalance when one asset class becomes disproportionately large.
The goal of diversification is not to collect mutual funds—it is to build a portfolio in which every investment serves a purpose. A simpler, well-structured portfolio is often more effective than a sprawling one filled with overlapping schemes. When it comes to mutual funds, smart diversification beats excessive diversification every time.