Over-diversification can ruin your portfolio
December 21, 2018 | Investopaper
Gaurab Subedi
You can invest in stocks of different sectors like banks, insurance, manufacturing companies, hydropower, hotels, microfinance, etc in Nepal. In order to reduce risk and maximize your return, you need to diversify your investments in these sectors. While designing your investment portfolio, you may also be inclined to a specific sector. For instance, commercial bank stocks may carry more weight in your portfolio. This preference is driven by many factors like return, riskiness, intuition, etc.
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Portfolio theory suggests that investing in different unrelated assets classes helps to reduce your risk. The concept is not to put all your eggs in one basket. Modern portfolio theory suggests that by investing in more than one stock, an investor can obtain the benefits of diversification by reducing the overall riskiness of the portfolio. It further asserts that it is possible to construct the set of an optimal portfolio offering the highest expected return for a given level of risk.
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“Commercial banks are considered to be a relatively stable sector in Nepalese market. In the month of Kartik, the mutual fund industry in Nepal preferred to buy commercial banks stocks. Nepal Bank Limited and NMB bank stock were their top choices. Also, the weight carried by the commercial bank is the most among different sectors i.e. around 36 percent. Similarly, microfinance carried 13.08%, life insurance around 12%, non-life insurance 11.39% and remaining sector carried 28.16%.in their stock portfolio.”
Generally, all of the investors agree with the concept and go with the diversification strategy. But it is extremely necessary to avoid over-diversification to get a good return. So, make a clear strategy before diversifying your investment.
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Before diversifying your portfolio, first, you have to assess the past performance (say recent five years), analyze the market trends, evaluate the future prospects and calculate the risks and returns of the stocks. Based on the analysis, make the investment strategy accordingly. Assigning weight is one of the significant tasks you need to carry out. For instance, you may prioritize to keep more stocks of the less volatile sector (commercial bank in case of Nepal) while some may prefer putting shares of the more volatile sector ( insurance sector in Nepal) to get magical returns. The risk-return approach also determines the portfolio decision of the individual.
“Life insurance and non-life insurance sector are considered one of the volatile sectors in the Nepalese market. As of December 18, 2018, the average price fall of 7 life insurance companies compared to 52-week high price stands at around 35% while the decline in price is around 37% for 15 non-life insurance companies. Similarly, the decline range is wider for non-life (17.42%-67.24%) as compared to the life insurance sector (24.83%-43.25%).”
Diversifying stock within a sector is also necessary. Putting some blue-chip companies in your portfolio will defend you when the market falls severely. Blending shares of big companies with small can be an appropriate diversification strategy to reduce the overall risk of a portfolio. For instance, stocks providing an average return that is trading at a cheap rate can be a good addition in your portfolio. This stock does not carry a high percentage in your portfolio and gives you a satisfactory return.
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Also maintaining a certain number of stocks in your portfolio is essential. For example, selecting 10-15 shares that are likely to rise is much easier than 20-25 shares. A large number of shares in your portfolio will give you just an average market return at best. Also, it will be easy to track the stocks in your portfolio if they are less in number. To sum up, the over-diversified portfolio may not give you an expected return.
Some stocks in your portfolio will definitely cause loss but you need not worry about that. If they carry a large percentage in your portfolio then you have to take it into consideration as it affects the overall performance of your portfolio. To get a consistent return in your share investments, holding good stocks in an appropriate number from different sectors in your portfolio is a must.
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I will take this as huge suggestion, thanks.