‘Don’t put all your eggs in one basket’ is an investment tenet that saves you a lot of stress. But some folks stretch this concept so far that they put their eggs in baskets they can’t even find later.

When Peter Lynch spoke of ‘diworsification’, he was referring mainly to companies that don’t stick to their core business and venture into unrelated areas that destroy shareholder value. But retail investors can be guilty of diworsification too. Watch out for the following types of diworsification in your portfolio.  

Owning too many funds

Mutual funds are investment products that embody the concept of diversification. The largest flexicap equity funds in India hold 40-50 stocks in their portfolios. For small-cap funds, the number ranges from 80 to 200. Yet, it is not unusual for Indian investors to own 20 or more equity funds in their portfolio, thinking that this achieves diversification. It actually has the opposite effect.

Owning more than 4-5 funds in the same category amounts to diworsification on three counts. If your funds have distinct portfolios, you may end up indirectly owning exposures to 400-600 stocks. As the number of investment-worthy stocks in India is 400-500, this is as good as buying up the entire market. Once you do that, you can’t expect your portfolio to outperform the market. A single Nifty50 or Nifty100 fund can do this job better.

If you own all the top funds in a category, it can lead to significant portfolio overlaps. This is because, as per SEBI mandate, Indian fund managers have a universe of just 100 large-cap stocks and 150 mid-cap stocks to choose from. Investing in the top three flexi-cap funds today will lead to your indirectly holding a 14 per cent exposure to just two stocks — HDFC Bank and ICICI Bank. Owning too many funds can also make your portfolio tough to monitor. If keen to diversify within mutual funds, own just 2 funds with differing investment styles in each category. 

Adding riskier investments

A key objective of diversification is to reduce risk at the portfolio level, by owning negatively correlated assets. When you add gold funds to an equity portfolio, this can smoothen out returns, as gold tends to rise when equities decline.   

But some investors interpret diversification as simply adding on more instruments. A senior citizen can get to an 8 per cent plus return today simply by investing in government-backed instruments like the Senior Citizen Savings Scheme (8.2 per cent) or GOI Floating Rate Savings Bonds (8.05 per cent). If she chooses to invest in a Shriram Finance FD offering 9 per cent or an Annapurna Finance NCD for 12 per cent, this is not really diversification. These instruments significantly increase portfolio risk for a higher return.  

Bond aggregators have taken to bundling many lower-rated NBFC bonds into a Securitised Debt Instrument (SDI) so that an investor can buy into this basket for ₹1 lakh or so. Such a basket may offer the investor a shot at double-digit returns, but he should be under no illusion that he is diversifying. Even if one of the seven or eight BBB or A-rated NBFCs making up the bundle defaults, he stands to lose part of his principal.    

Taking on more volatility 

Diversification should ideally help reduce volatility at the portfolio level. Adding high dividend yield stocks to a portfolio of high growth stocks can help contain downside in turbulent markets. But when a new product or asset makes your portfolio value more volatile than before, that constitutes diworsification.

For Indian investors looking for high safety with a reasonable yield, investing in domestic money market funds is a good bet. These funds invest in 91-day to 364-day treasuries issued by the Government of India. In the last ten years, money market funds have seen their annual returns fluctuate between about 3.6 per cent and 9.6 per cent, with no loss-making periods.

Recently, Indian AMCs have been rolling out funds that invest in US 1-year to 10-year treasuries. They hold out the prospect of making a higher return from elevated US treasury yields (at about 5 per cent) and Rupee depreciation.  

But moving from the safety of Indian money market funds to US treasury funds changes the nature of your portfolio. Yields on US treasuries tend to be far more volatile and tough to predict than those on Indian treasuries. US 1-year treasury yields have swung between 0.03 and 5.5 per cent in the last three years. The Rupee’s moves against the dollar add another layer of volatility to returns from these funds. Therefore, while such funds may make sense for investors who seek a dollar hedge, they are not a good diversifier for those owning Indian debt funds.

Assets you don’t understand

For good investment results, it is important to stick to investments you understand well and can keep track of. Straying from a market or asset that you know thoroughly, into one that you barely get, is diworsification.

Indian investors who strayed from domestic equity funds to international funds investing in Brazil and China, because their past returns looked good, have burnt their fingers in the last five years. Political upheavals and high commodity dependence have made for volatile returns from Brazilian markets, while a patchy Covid recovery and stalling economy have dogged Chinese equities. This, at a time when the Indian economy and markets have performed well. Diversifying from traditional assets into crypto currencies or from bank FDs into crypto deposits would also fall neatly into the description of diworsification.

Watch out for
Portfolio overlaps
Lower capital safety
More volatile returns 
Less-known products