Mutual Funds Sahi Hai? Part 1: Excess-Diversification ❓

We all know the benefits of diversification. Don’t put all your eggs in one basket has been preached since our childhood - but when it comes to equity mutual funds we feel it is highly overdone. So much that you are almost allotting a basket for each of your eggs. That much TLC for your eggs (and portfolios) is nothing short of an overkill.

The right balance

Any equity mutual fund typically has 50-70 stocks. There is a simple balance needed for any portfolio to perform well. The balance has to be between:

1. Performance - Imagine a few stocks perform very well, but their weight is too little in the portfolio. At a portfolio level, the outperformance hardly moves the needle.

2. Risk - On the other hand, imagine there are only a few stocks and the markets perform poorly, and these stocks in the portfolio perform even worse. The risk of losing out is massive here.

Somewhere in the middle is a sweet spot which makes sense. Do you get that by holding 50 stocks? Or 70? Or even 100?

💡 The optimum number of stocks in a portfolio is 15-20. The number of equity mutual funds with only 15-20 stocks is 0.

Risk reduction has a limit

In any portfolio, you would ideally want MORE returns at LESS risk. Usually, with more risk, comes higher return, but also higher potential of loss. In short, there’s a trade off. In mathematical terms, you would like to optimise your portfolio by generating higher returns for lower variance.

For a single stock portfolio, Variance of portfolio = Variance of stock. For a multi-stock portfolio, Variance of portfolio = Variance of all the stocks per their weight in the portfolio + the covariance between each of the stocks.

Now, as the number of stocks increases, variance comes down. The risk of one stock reduces the risk of another. The more the number of stocks, the more they will cancel each other out.

But then the risk of covariance between stocks can't be cancelled out. That is the market risk one has to accept. For example, we dip into a recession tomorrow, all stocks will be impacted. Diversification won’t cancel the risk out and keep you safe. That’s the market risk.

With each additional stock, the amount of risk that goes down reduces

But here’s the catch - when you go from 1 stock to 2, you reduce the risk massively, and then you add the 3rd stock and risk reduces by a little lesser, the 4th stock even lesser, and the 5th even lesser, and this continues.

In a research by Aidan Eccles, Lindsey Coffey and Derek Horstmeyer of the CFA Institute,

The average volatility of a large-cap 10-stock portfolio was 20%. A more diverse large-cap portfolio of 40 stocks only lowered volatility to 17%. So adding 30 stocks reduced volatility by just 3 percentage points.

💡 For large-cap portfolios, there’s little to be gained by diversifying beyond 15 stocks or so.

Mathematically, portfolio variance will always converge towards market risk (covariance between stocks) as you add more stocks in the portfolio.

But adding more stocks stops making sense when the additional benefit of adding another stock (incremental reduction in variance) is lower than the additional peril of adding another stock (incremental reduction in returns).

The ideal number

Mathematically, the trade-off is optimum at between 15 and 20 stocks. However, this can vary depending on the correlation in the market we are talking about, the theme we are investing by and the situation at that time.

Over-diversification

In any case, nothing justifies the benefits of having 50-70 stocks in your portfolio. By doing this, you are just excessively diversifying. You are lowering risk, but also reducing the amount of return you can earn.

After all, what’s the point if a stock doubles, but it is just one of the 100 stocks in the portfolio, with a 1% weight?

On top of this, people buy multiple equity mutual funds, which further increases diversification, leading to sub-optimal returns.

Possible solutions

1. Make your own portfolios

2. Buy index funds, and then add a few stocks on top of that to get the right portfolio balance

3. Buy a bunch of stocks that are curated by professionals, but that don’t over-diversify (READ: Invest with Rupeeting!)