Think for a moment. Do you have many mutual funds in your portfolio? Or fixed deposits in several banks that you last count of? If so, you suffer from what we call as “Regret Alleviation”. In this article, we explain why you do not always have to diversify your investments. Our discussion is based on the core-satellite framework.

“Regret Alleviation”

If you are in doubt about your investment decisions, you diversify! For that is the easiest way to reduce regret. Besides, you face peer pressure to diversify. We call this behaviour to diversify as “Regret Alleviation”. Why? If you do not diversify, and your portfolio declines in value without the entire market tanking, you will experience regret; for the investments you did not hold declined less. You, therefore, diversify to moderate likely regret that your lack of diversification may lead to more losses on your portfolio compared to the broad market.

But should you always diversify? To answer this question, consider the core-satellite framework. In this approach, your core portfolio consists of goal-based investments and your satellite portfolio consists of investments and products geared to capture short-term fluctuations in the market. Typical core portfolio consists of passive investments and the satellite portfolio, active investments.

In this framework, the core portfolio will have index funds for equity investments and bank fixed deposits for bond investments. Consider a Nifty Index Fund, a typical investment in a core portfolio. All Nifty Index funds will generate similar returns, as they hold the same portfolio and have similar management expense ratio (MER). So, why hold more than one index fund in your portfolio?

Of course, it is somewhat different with bank deposits. You may fear that your bank may default on your deposits at maturity! This fear prompts you to spread your deposits across several banks. But, remember that banks are highly regulated in our country. So, the possibility of default on your bank deposit may be small. That said, for peace of mind, spread your deposits across 3 banks, but not more. Why? You may find it difficult to manage your investments when you increase the number of products in your portfolio.

Active risk

What if you decide to invest in active funds? Your “Regret Alleviation” would then be justified! For, the feeling of regret could be high if you invest in an active fund that eventually underperforms the benchmark index. You would then wish you had instead bought an index fund! This risk of underperformance of an active fund is called active risk. This argument is also true if you buy bond funds instead of investing in bank deposits.

What about your satellite portfolio? The objective of this portfolio is to take aggressive bets and earn high returns from short-term fluctuations in the market. So, diversification cannot be beneficial, as it could drag the returns on your satellite portfolio! You should instead create a concentrated portfolio- trading large quantities of fewer stocks at regular intervals and actively manage the investment risk.

There is an exception to the above argument. You may want to diversify your investments in your satellite portfolio if you choose to buy mutual funds instead of making direct investments. But instead of buying three different mutual funds of the same kind, you should consider buying one sector fund, one mid-cap active fund and one small-cap active fund. Your investments will be then exposed to active risk, but that is the price you should be willing to pay to earn higher return.

Finally, beware your diversified portfolio may not provide you downside protection during global crisis, such as in 2008. The reason is because all assets typically tank in such extreme conditions. So, remember this: Diversification may not necessarily lower your active risk. But it does help in “Regret Alleviation”.

(The author is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in)

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