InvestorQ : Are there are serious risks that my diversification may actually go wrong?
Anjana Aiyar made post

Are there are serious risks that my diversification may actually go wrong?

Deepa Salunkhe answered.
3 years ago

Actually, diversification can go wrong in a number of ways. Too much diversification is as bad as too little diversification and we shall see this point in detail later. Diversification can go wrong either if you do too much of it or too little of it. For example, a portfolio invested 100% in equities can be risky even if it is spread across a diverse set of stocks You also need other asset classes like bonds, liquids and gold to give stability and certainty to your returns. While your overall returns may come down, your risk adjusted returns will be higher in this case. The index risk in equities itself can be quite high. Also if your diversification is done across sectors and themes that still have high historical correlations, then the diversification is unlikely to work. For example, auto, NBFCs and real estate may look like 3 different sets of investments altogether. But the common threads between these two sectors are liquidity and interest rates. When rates are falling and the market is liquid, all the three sectors perform well. In the reverse situation, they all do badly. Even if you spread your money across these three sectors, you could still run a huge theme concentration risk. So correlation among assets is the key to getting adequate diversification.

Is it also possible that I over-diversify? If you keep adding stocks that are not reducing overall risk then it means you are only substituting risk and that is equally harmful to your portfolio. The celebrated investor, Warren Buffett, called this “diworseification”. Typically, diversification works if you can add up to 12-14 stocks with correlation adjustments. Beyond that you only have risk substitution and not risk reduction. That is the point, when most of the risk that you could have reduced is already reduced and hence you have little leeway left to reduce your risk further.

When it is about understanding the risks of diversification pertaining to spreading your risk via diversification two basic things need to be remembered. First, if you don’t have time, knowledge or desire to monitor the diversification, delegate to a manager like a mutual fund or a PMS or an ETF. Secondly, you can do it on your own provided you maintain some basic discipline. Set Limits for yourself in terms of number of stocks you will add in your portfolio and limit to 12-14 stocks across 4-5 sectors only. At the end of the day, diversification in any form entails giving up on some returns. You can only achieve that if successfully if you managed to get rewarded for every unit of risk taken.

Remember that diversification is all about not putting all your eggs in one basket. It is about spreading your risks. In other words, diversification is the antithesis of concentration. When you put all your money in one or two investment products then you run the risk of concentration. That means, you predicate your entire investment performance on the performance of just a handful of stocks or assets. That is not a smart thing to do, especially when you are relying on these investments to meet your long term goals like retirement, child education etc. A better idea would be diversify your risk smartly.