Diversification a fundamental norm of investment

I get a good quantity of emails from people asking for investment advice. Most of the problems fall within a narrow set. There are perhaps five or six common issues and nine out of ten investment queries are variations of these. Only a small percentage of people have an unusual problem that they are trying to cope with.

Recently, I received an email that is an extreme example of a common problem. The sender is a young man in his early twenties who has just started a high-paying job. He finds himself able to save almost a lakh of rupees a month. He has decided to invest this money through mutual funds, and since he is young and his time horizon is long, he would like to put all the money in equity funds. He has chosen a set of diversified equity funds and has started SIPs in all of them.

So far, so good. However, his list has 24 funds on it — many more than it should. This is an extremely large number of mutual funds for one person to invest in. There are many disadvantages to investing in such a huge number of funds. First and foremost, a major attraction of investing in mutual funds is the convenience. Keeping track of a large number of mutual funds completely negates this. With 24 SIP plans, one is tracking 288 investments a year, which is not inconsiderable.

And making the investments is just the start of the story. At least once a quarter, such an investor would have to look at each fund’s performance, give some thought to how it is doing, whether it is living up to the purpose for which it was bought. This would make sense only if some great purpose was being served, but that is not the case either.

Admittedly, diversification is one of the fundamental principles of investments. The idea of diversification is straightforward. Stocks of different kinds of companies tend to do well or do badly at different times. By ‘different types of companies’ one could mean different sectors, different parts of the world or even some financial parameter like different levels of interest cost or forex exposure. Of course, there’s many a time when there are broad-based declines when the diversification that works consists of being out of the stock markets altogether.

However, such diversification is taken care of by the fund managers who are running mutual funds. For the investor who is putting his money in funds, the only diversification that is needed is between different fund managers. At a given point of time, one or the other fund manager may not make correct judgements, and having more than fund protects an investor against that.

In my experience, four or five funds are quite enough to provide this kind of diversification. No additional diversification is provided by investing in more funds. The reason is that the stocks held by these funds tend to be a similar set. With a larger number of funds, you are effectively adding more funds that are similar to some other fund that is already there with you. In effect, you end up adding a lot of paperwork and housekeeping without gaining any further diversification.

Of course, most investors who have overlarge portfolios end up that way because of pressure from fund salesmen selling new funds. Because fund salesmen earn far more when selling NFOs, they aggressively pitch new funds to their clients.

My friend with 24 SIPs is a rarity, but at least, he will end up with a defined number of funds. I know people who’ve made a series of small investments in innumerable NFOs. This kind of investing is impossible to manage and serves no purpose at all.

(The writer is Founder and CEO at Value Research)