People, when doing something unfamiliar, often seek advice from others. Sometimes, this advice is vague, which can lead to a series of unfortunate events. In today’s article, we will discuss one such piece of advice that causes a strange phenomenon called overdiversification, and how to avoid misinterpreting it.
Most people investing in mutual funds hear this one golden rule over and over again: “Don’t put all your eggs in one basket.”
In simple terms, it means you should not put all your investments into one organization, as you may suffer losses.
Diversification is true and sound advice. However, due to a lack of experience, many people fail to understand its unsaid meaning. “Do not put all your eggs in one basket” means you should spread them across different baskets, but not into baskets that are beyond the reach of hen which will turn your eggs into profits.
If you are a mutual fund investor and want to avoid diversification that causes your money to fall into a bottomless pit, read our guide on how to avoid overdiversification in mutual funds.
What is Over Diversification?
Overdiversification happens when you invest in too many mutual funds, thinking it will reduce risk, but instead it limits your growth. For example if you invest small amount in 15 to 20 equity mutual funds, many of them may be holding the same stocks, like Reliance, Infosys, or HDFC Bank. On paper, it looks diversified, but in reality, you are repeating the same exposure again and again.
Why Investors Do Overdiversification?
Most investors do not intentionally sabotage their mutual fund. It usually happens due to common habits and fears that persist in the human mind.
1. Fear of Losing Money
Many people believe that investing in more funds equals more safety. Whenever markets fall, they add another fund instead of reviewing existing ones properly.
2. Following Too Many Suggestions
A lot of people give free advice. Friends, relatives, social media influencers, and YouTube videos all suggest different funds. However, they will not help you when the situation demands it, because they are not experts. Instead of choosing funds based on what every Tom, Dick, and Harry says, investors should make decisions by listening to qualified mutual fund advisors. When they don’t, investors often end up buying a little of everything.
3. New Fund Offers Temptation
There is a false belief that every new thing is an opportunity. In a way, they are opportunities, not always for success but sometimes for failure. Not every new fund is a recipe for disaster though, but one must fully research before making any major decision.
4. Lack of a Clear Goal
When you invest without clear goals, you keep adding funds randomly, which creates confusion and overlap and eventually stagnant growth.
Why Overdiversification Is Not Good
At first glance, spreading your investments to different places looks safe. In reality, it comes with hidden problems you initially don’t realize.
1. Lower Returns
When you hold too many funds, high-performing ones get balanced out by average or poor-performing funds. Think of it like unhealthy plants spoiling a prized plant that once gave flowers every week, but now produces only a few. In a similar manner, in mutual funds, your overall return becomes mediocre.
2. Duplicate Holdings
Many mutual funds invest in the same top companies. Owning five large-cap funds often means owning the same stocks five times which won’t help you when they fall.
3. Difficult to Track
Managing and reviewing 12 to 15 funds is stressful. You may miss underperforming funds simply because tracking becomes too complex and too time consuming.
4. No Real Risk Reduction
True diversification means investing across asset classes and strategies so that risk is spread across different industries, not merely spreading money across similar funds with different names.
How to Avoid Overdiversification
You do not need expert financial knowledge to avoid overdiversification. Simple thinking and a few basic steps are enough to make better investment choices.
1. Define Your Investment Goal
Before investing, you should know why you are investing. It could be for retirement, your daughter’s education, or future wealth or daughter’s wedding. When your goal is clear, you will not buy extra or unnecessary funds and your money will stay focused on things that matters.
2. Check Fund Overlap
Many mutual funds invest in the same top companies. Before adding a new fund, check if it holds the same stocks as your existing funds. If the overlap is high, adding that fund will not reduce risk and should be avoided.
3. Quality Over Quantity
Having many funds does not mean better returns. It is better to invest more money in a few good funds than to spread small amounts across many average ones. Good-quality funds perform better over time, bad ones will dilute returns of well performing ones.
4. Review, Do Not Add Blindly
Instead of adding a new fund every year, review the funds you already own. If a fund is performing well and still matches your goal, there is no need to replace it. Let strong funds continue to grow and do their thing.
5. Avoid Emotional Decisions
Market ups and downs are normal and should not cause panic. Adding new funds during every market volatility only creates confusion and loss. Staying calm and following your plan helps protect your investments.
Final Thoughts
Overdiversification can hurt your money without you knowing it. Having some different mutual funds is good because it protects your money. But having too many funds can slow down how fast your money grows. The goal of mutual fund investing is not to buy many schemes, but to grow money slowly, safely, and peacefully.
Mutual fund advisors say it is important to trust your plan. They advise choosing a few good funds and staying patient for a long time. Adding new funds again and again without a clear reason can create confusion and reduce returns.
Keep your portfolio simple and based on your goal. Choose funds that are easy to track and understand. A clean and well-planned mutual fund portfolio often works better than a crowded one and helps you feel more confident about your investment decisions.