What is overdiversification? How to avoid it while constructing a portfolio?

Many investors really do not understand this concept while investing. But over-diversification leads to poor portfolio management as well as a decline in overall profits due to unnecessary costs.

Over diversification means

# You are investing in a similar type of mutual funds from 2 different AMCs or

# from the same AMC where those funds are investing in a similar set of stocks.

Because of this, it may seem that you are investing in 2 different mutual fund schemes but actually, you are unnecessarily paying management charges and other charges for buying similar stocks.

Diversification should be done across asset classes, not only among similar financial instruments from one asset class.

Here are 5 main asset classes and some financial instruments belonging to them

  1. Cash and cash equivalents: Bank balance, Sweep in / Link in FDs, and hard cash
  2. Debt asset class: FDs, RDs, Postal Schemes, PPF, EPF, SSY, and debt mutual funds.
  3. Equity asset class: Direct Stock and Equity Mutual funds: Largecap, Multicap, Flexicap, Hybrid Equity, Midcap, and small-cap funds.
  4. Gold: Sovereign Gold Bond, Gold funds, and physical gold.
  5. Real estate: Commercial property, Agricultural land, Residential land and house, and REITs.

From this list first 3 asset classes are liquid asset classes and should be used to meet your financial goals. Gold and real estate should not be used as the main investment instruments. They should be used mostly for self-consumption.

For getting rid of over-diversification kindly first decide asset allocation at the portfolio construction level. For a long-term goal, one can have an allocation of 60/65% in Equity and 40–35% in Debt. Once you decide on this allocation now you need to carefully decide the financial instruments.

Let me share the example where the detail of the financial instruments is provided which may be helpful to choose according to your financial goals. This strategy makes sure that overlapping is minimal as well your risk is well diversified.

Financial instruments for Short term goals will be the same irrespective of age group.

These goals can be divided into 1 to 3 yrs and 3 to 5 yrs.

For 1 to 3 yrs goals your asset allocation should be 100% Debt which will have

  • FDs
  • RDs
  • Liquid funds and overnight funds.

For goals up to 5 yrs, you can add Arbitrage funds

NEVER EVER think of investing in any Equity Fund for short-term goals even if you find a 1-year equity return very lucrative. For goals less than 1 year stick to saving bank account or 12 months RD only.

So for 3–5 years invest in liquid funds, recurring deposits, Arbitrage Fund. You can also convert the RD maturity amount into FD.

Financial instruments as well the asset allocation ratio for Long term goals changes with the different age group

  • If your goal is 20+ years away and you are in your 30s.

You can invest in the following the proportion of these assets

5% gold, 5% cash, 25% in debt and 65% in equity

  • In the Equity asset class you can have
    • 10 to 15% direct equity exposure but only in bluechip stocks as per your risk profile and desired exposure
    • Rest 50 to 55 % invest in Equity Mutual Fund as the following proportion
      • 60% in an index fund
      • 20% in an aggressive hybrid fund
      • 20% in mid and small-cap
  • In the Debt asset class, you can have
    • Invest in EPF and VPF (salaried) and PPF, NPS(self-employed) for the compounding effect of long term
    • invest in Debt Mutual Fund as following
      • For 20 years term horizon, you can think of going for a 10-year gilt fund
      • and rest in the arbitrage fund. Do not go with long term debt fund as they are interest-rate sensitive and carrying credit risk
  • In the Gold asset class, you can have
    • Sovereign gold bonds (SGB bonds)
    • Gold ETFs
  • You can hold Cash in the form of
    • Bank balances, Fds
    • Short term government bonds
    • Money market debt funds
  • If your goal is 10+ years away and you are in your mid-40s.

You can invest in the following proportion of these assets

10% gold, 5% cash, 35% in debt and 50% in equity

  • In the Equity asset class, you can have
    • 5% direct equity exposure but only in bluechip stocks as per your risk profile and desired exposure
    • Rest 45 % invest in Equity Mutual Funds as the following proportion
      • 50% in an index fund
      • 35% in an aggressive hybrid fund
      • 15% in mid and small-cap
  • In the Debt asset class, you can have
    • Invest in Bank Fixed Deposits or National Saving Certificate if you are a defensive investor
    • invest in Debt Mutual Fund as following
      • For 10 years term horizon, you can think of going for a 10-year gilt fund but as this is interest risk-sensitive you should think of coming out of it 2/3 years prior to your goal.
      • and rest in the arbitrage fund as well as liquid funds. Do not go with short term debt fund as they too are interest-rate sensitive and carrying credit risk
  • In the Gold asset class, you can have
    • Sovereign gold bonds (SGB bonds)
    • Gold ETFs
  • You can hold Cash in the form of
    • Bank balances, Rds
    • Short to ultra term government bonds
    • Money market debt funds
  • If your goal is 7+ years away and you are in your 50s.

You can invest in the following proportion of these assets

5% gold, 25% cash, 50% in debt, 15% in hybrid debt and 5% in equity

  • In the Equity asset class, you can have
    • 5 % in a multi-cap fund if you are a high-risk taker.
    • 15 % in an aggressive hybrid equity fund
    • 0% equity exposure if you are a defensive investor
  • In the Debt asset class, you can have
    • Invest in Bank Fixed Deposits
    • invest in Debt Mutual Fund as following
      • Liquid Fund
      • Arbitrage Fund (if you can take some risk)
      • and rest in the overnight funds (100% if you are a defensive investor). Do not go with any short term debt fund as they are interest-rate sensitive and carrying credit risk
  • In the Gold asset class, you can have
    • Sovereign gold bonds (SGB bonds)
    • Gold ETFs
  • You can hold Cash in the form of
    • Bank balances, Fds
    • short term government bonds
    • money market debt funds

You can consider the most suitable funds in each category to invest.

I hope before starting your investment you

# Fix the tenure of the goal,

# Do your risk profiling and

# Select suitable financial instruments as per required asset allocation.

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