The Hidden Risk of Over-Diversifying Mutual Funds

Imagine a circus performer walking a tightrope high above the ground. On one side lies the risk of falling due to imbalance; on the other, the fear of being too cautious and never reaching the end. To walk the tightrope successfully, the performer uses a long balancing pole—neither too short nor too heavy, just enough to maintain control and adjust to every subtle movement.

This balancing pole is similar to the strategy of mutual fund diversification. Too little diversification, and your portfolio may plummet during times of volatility. However, the excessive weight of too many mutual fund schemes can limit your returns, leaving you with average performance and unnecessary complexity.

“The idea of excessive diversification is madness. Wide diversification only guarantees ordinary results,” Charlie Munger.

What Is Mutual Fund Diversification?

Diversification in mutual funds means spreading your investments across different types of funds, such as large-cap, mid-cap, small-cap, debt, hybrid, flexi, thematic, or sectoral funds. This strategy is not only about managing risk but also about aligning your portfolio with your financial goals, which many investors overlook.

It’s the classic “don’t put all your eggs in one basket” strategy. However, spreading your eggs across similar baskets can lead to inefficient results. Investing in multiple funds that overlap in strategy, style, or holdings adds clutter to your portfolio.

Need for Diversification: Attention Required

It is commonly understood that diversification helps manage risk and deliver efficient returns. However, balanced diversification “averages market rallies and market corrections.”

A well-executed diversification strategy can protect you during market volatility and deliver competitive returns during a bull run. For instance, during the COVID-led market crash in March 2020, the Nifty 50 tumbled 38% from its January high, but losses were significantly higher—up to 50%—in mid- and small-cap segments.

On the flip side, during the recovery phase from April 2020 to December 2021, mid- and small-cap investments rose much higher than large-cap funds. Investors overweight in large-caps or debt funds experienced stability, while those in mid- and small-cap funds enjoyed the full momentum of the rally.

The takeaway is simple: your portfolio diversification should neither be overly stable nor excessively risky. Your investments should weather volatility without missing out on bull market opportunities.

What’s Wrong With Your Approach?

Many retail investors passionate about “do-it-yourself (DIY)” investing overlook critical parameters when diversifying their mutual fund portfolios. Here are some common mistakes that lead to over-diversification:

• Diversification for Mental Satisfaction: The fear of missing out (FOMO) often influences investment decisions. Investors chase returns from auto rallies, defense stocks, or green energy without considering their goals. This distraction leads to over-diversification, satisfying short-term impulses while starving the portfolio of meaningful returns.
• Multiple Advisors: Seeking advice from amateur investors can result in a cluttered portfolio with a variety of funds. While this may appease your advisors, it often fails to align with your goals. Consulting a trusted mutual fund distributor can help filter funds that match your objectives.
• Dilemma of Passive & Active Funds: Investors often fall into the trap of blindly mixing active and passive funds. During market downturns, passive funds mirror the tracking index and follow its declines. In contrast, professionally managed active funds may reduce exposure to falling sectors, hold cash to mitigate volatility, and adjust allocations accordingly.
• Duplication of Funds: A common mistake is buying different funds within the same category or with similar approaches and calling it diversification. This duplication undermines the purpose of diversification, as the investments face similar consequences when markets falter. Always analyze mutual funds based on various parameters before adding them to your portfolio.

A Complicated Act of Balancing

Diversifying your investments to manage risk, tolerate volatility, and align with your goals is a complex exercise. It requires regular rebalancing to keep your portfolio aligned with your objectives. Choosing a mix of complementary funds—rather than duplicative ones—that match your goals and time horizon is essential.

In this journey of wealth creation, the courage to say “no,” commitment to your goals, and disciplined investing are constant challenges. MINTIT brings the effort, guidance, and reminders needed to stay on track.

MINTIT, India’s dedicated mutual fund platform, caters to your personalized goals and supports you in achieving your financial milestones. Based on your profile, it suggests tailored mutual funds to help you meet your objectives.

Start your SIPs today under professional guidance and build a nest egg for your financial security with a well-diversified portfolio.

Happy Investing! Stop Thinking, Start SIPing.