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Wednesday, June 19, 2013

Is Your Portfolio Over Diversified?

Don’t Put All Your Eggs in the Same Basket is an age old saying that holds good for our investments too. That is why we have Portfolio Diversification. Investors are encouraged to select multiple asset classes and spread out their investments between them so that, in case one asset class fails (like what happened to gold prices in the past few months) the other asset classes can help prevent extensive damage to your portfolio. Sounds good doesnt it?

Unfortunately, the average Indian Investor fails to understand this concept and ends up over-diversifying his/her portfolio which can have counterproductive effects. The idea behind this article is to try to understand what Over-Diversification is and how to curb our impulse to over-diversify our portfolio.

Before We Begin: If you are someone who hasnt accumulated an investment portfolio yet, I would strongly urge you to read the articles under the Investment Portfolio page and understand how to create a portfolio for yourself.

So, what is Over Diversification?

Over Diversification is a term that is used to signify a portfolio that has too many instruments.

Go back to the first line of this article — Don’t Put All Your Eggs in the Same Basket. Let us say I am carrying 100 eggs from my house to my friends place. So, to avoid the risk of breaking the eggs, what do you think is a reasonable number of baskets?

4 baskets with 25 eggs each?

5 baskets with 20 eggs each?

10 baskets with 10 eggs each?

50 baskets with 2 eggs each?

100 baskets with 1 egg each?

The first or second option of carrying my eggs in 4 or 5 baskets is an example of diversifying my portfolio thereby reducing my risk. The last two options of 50 or 100 baskets is what is meant by over diversification.

Even though your chances of taking all of the eggs safely to your friends place are going higher as you increase the number of baskets, you need to draw the line at the point where the number of baskets actually becomes an overhead and ends up hurting your process.

Are you still not clear? Let us do some numbers to understand.

Let us say each basket can carry up to 50 eggs but there is a chance that 4 to 5 eggs can get damaged if you load the basket beyond 20 eggs.

Let us say each basket costs you Rs. 5/- and each egg costs you Rs. 3/-

Technically speaking, if you buy 5 baskets and put 20 eggs each, you will end up spending Rs. 25/- more but your chances of all 100 eggs reaching safely are considerably higher. But, to carry eggs worth Rs. 300, do you think it is a good idea to buy baskets worth Rs. 250 or Rs. 500?

If you buy 5 baskets and spread out your risk that is DIVERSIFICATION.

If you buy 100 baskets and spread out your risk too much that is OVER DIVERSIFICATION.

Get the picture?

A Real-Life Over Diversified Portfolio:

I can hear you mumbling, enough of this story on eggs, lets talk money sense and find out what a real-life over diversified portfolio would look like.

Let us say Mr. X has a portfolio worth Rs. 50 lakhs which he is accumulating for his retirement. He has invested across the following asset classes:

1. Equities

2. Mutual Funds

3. Gold

4. Real-Estate

5. Bonds

6. Bank FD’s and

7. ULIPs

Can you sense the over diversification already?

His Equity Portfolio consists of around 50 stocks across the large, mid and small cap space. He has invested in 23 MF schemes (More the merrier, isnt it?) and has invested in 12 corporate Bond Issues. He also holds FD’s in 6 different banks and has 4 ULIP Plans.

What are the Drawbacks of an Over Diversified Portfolio?

The biggest drawback is the difficulty in tracking your portfolio performance.

Any good investor would periodically (at least once a quarter and preferably at least once a month) revisit all his investments and check if they are performing as expected. This would give him/her an opportunity to eliminate any bad performing stock or fund and replace it with something that will perform better.

Imagine the difficulty if you had to review 50 stocks, 23 mutual funds, 12 bonds every month and find out what is performing well and what isnt?

Because of the sheer volume, you will end up overlooking key facts and details that may hurt your investment in the long run.

For ex: Let us say MF Scheme A is a part of Mr. X’s portfolio for 5 years now. It was the top performing fund in 2008 when he bought Rs. 50,000/- worth units. It was an aggressive diversified equity scheme and currently his investment is worth Rs. 60,000/- which works out to a meagre 4% returns on an average over the past 5 years. Do you think Mr. X should remain invested in this scheme when the category average for equity mutual funds is much higher and even a bank FD would’ve earned him 8% per year?

If Mr. X had say 6 or 8 schemes in his portfolio, he could’ve easily located such bad performers during his quarterly review and weeded them out. But, since he has so many schemes, he just overlooked it and has ended up making real poor returns.

Trivia:

Easily 50% or more of the MF schemes that are launched end up as mediocre or worse end up causing people to lose money. All Equity investments come with a risk and if you invest in a scheme that either takes too many or too little risks, you will end up losing money instead of making profits. Only a few MF schemes have been able to consistently outperform their peers for a period of over 5 years. You should concentrate on such funds and invest in them. Fund houses usually focus on their new fund and make it generate extraordinary returns for 2 or 3 years and then lose track of it. Eventually such funds end up in the mediocre or bad performing list. A smart investor always identifies such funds by comparing the funds returns with the category average every quarter to ensure that his/her fund is performing well.

So, What is a Good or Well Diversified Portfolio?

A Well Diversified Portfolio will have exposure to at least 3 or 4 asset classes. Remember, you need not have exposure to all asset classes to form a diversified portfolio. A healthy combination of Equities, Mutual Funds and Bank FD’s are more than enough to form a good portfolio. Add in a little bit exposure to Gold and your portfolio goes from Good to Very Good.

An Ideal number of entities in each of the categories would be:

1. Equities — 10 to 12 stocks with at least 50% exposure to Large Caps. 30% to Mid-caps and 20% to Small-Caps. No single stock should be worth more than 10% of your Net Equity Portfolio worth

2. Mutual Funds — 6 to 8 Schemes with at least 1 each in the following categories: Equity Diversified, Large Cap, Mid & Small Cap, Balanced and Long Term Debt. Based on your risk appetite you can add one more good scheme in each of these categories but I would personally put the cap on 10 schemes — This is the absolute Max.

3. Bonds — 4 to 6 good Bond Offers

4. Bank FD’s — Choose 2 banks — One Private and one Government and split your FD’s across these 2 banks. If you are tempted by awesome interest rates offered by any other bank, go ahead but keep 3 banks as the absolute Max.

A Tip About Fd’s:

Dont have only one or two FD’s. Split up your surplus and invest it across multiple FD’s. If I had Rs. 1 lakh as surplus today, I would probably split it up as 2 or 3 FD’s and deposit it. This is because, in future if I need Rs. 30,000/ urgently all I need to do is, break just one of those FD’s and the others remain untouched. Practically speaking, do you think that if you break the 1 lakh FD, you can be sure you wont spend the remaining 70,000 too? We always end up doing that. So, better to split up FD’s into multiple chunks so that it is easier to withdraw in case of any emergency.

5. ULIPs — I have always been sceptical about ULIPs due to the high cost that we end up paying to the agent and the insurance co. These days ULIPs have realized that and are coming up with good schemes with competitive fees & charges. If you want to have exposure to ULIPs, I would suggest you limit yourself to 2 or at most 3 ULIP Schemes.

Arent we forgetting something?

Pause for a moment and ask yourself. Arent we forgetting something?

Insurance Policies

Even though Insurance Policies cant be considered an investment, in India a majority of the population considers Insurance Policies as Investments. You find out a random stranger in his 40’s and ask him what are his investments, there is a 50 to 70% chance that he will say I have N Insurance policies worth Rs. X lakhs. No matter how much we try to explain to people that Insurance and Investment must not be confused, people will still continue to purchase Insurance Policies for Investment Purposes. So, if you look at a person’s portfolio you will end up finding multiple Insurance Policies.

Now that we have actually started talking about Insurance Policies, what do you think is a reasonable number of policies for a person?

Whatever I explained above about Equities and Mutual Funds holds good for Insurance Policies too. Too many policies is not good for you. (It is very good for your Insurance Agent though, but that is not part of this article. We are only talking about what is good for you the INVESTOR). Try to limit the number of Insurance policies to 4 or 5. Your Insurance agent is going to try to convince you to buy a new policy every year during the tax planning season. On top of that, these Insurance companies come up with newer schemes every 2 to 3 years. So, every time this happens you can expect a visit from your Insurance Agent. Don’t just buy insurance policies out of impulse. Think first and keep the number to around 5.

The general rule of the thumb is, you must be insured to at least 6 to 10 times your annual salary. So, if you are earning Rs. 5 lakhs ever year, you must have insurance worth at least 30 lakhs to 50 lakhs. If you already have 50 lakhs worth insurance and switch to a job where your salary is 8 lakhs, you will have to take a new policy to cover the additional income. In such a case, go for the higher limit — 10 times and wait for your salary-insurance ratio to come down to the 6 times number before you buy an additional policy.

Some last words:

The main reason behind maintaining a portfolio is to save up for our retirement and to make an additional income source. Over-Diversification can kill returns and make portfolios unmanageable. So, be a smart investor and prune your portfolio for unwanted instruments and keep your portfolio in peak shape.

Happy Portfolio Diversification Folks.