Long-Term Investing: Should You Diversify or Concentrate?

Diversification Within an Asset Class: An Example

Diversification in investing helps lower the risk associated with investment options due to market fluctuations. So if some of your investment options don’t perform well, they are typically balanced by higher returns from other ones.

Diversification doesn’t always mean putting your money in different types of assets like debt, equity etc. You can also do diversification within one type of asset. This is called diversification within an asset class. Let’s understand this with a simple example.

Suppose you decide to put your money only in equity mutual funds. That means you are choosing just one asset class: equity. But even within equity mutual funds, you don’t need to stick to just one type. You can mix and match different types of equity funds.

For example, you can choose:

• Large-cap funds : These funds concentrate on investing in top 100 India’s biggest and most well-established companies.
• Mid-cap funds : These invest in medium-sized companies which are from 101 to 250th and aim to offer investors a balance between growth potential and risk.
• Small-cap funds : These invest in small or new companies that are from 251th onwards and may grow in the future.
• Multicap funds : These invest in companies of all sizes.
• Sectoral funds : These invest in a particular industry, like pharma, IT, or banking.

The different investment funds within your portfolio will perform independently of each other.

Other asset classes follow a similar investment strategy. As a debt mutual fund investor, you can divide your funds between money market funds, corporate bond funds and gilt funds etc to distribute your risk.

To minimize risk while investing in a preferred asset class, you should spread funds across different types within that category. You can balance the safety and growth of your investments by distributing funds across various asset classes, protecting your investments from market ups and downs.

The Pros and Cons of Diversification

Let’s understand the good and bad sides of diversification in investing in simple terms.

Pros of diversification:

• Reduces risk: If one investment does badly, others might do well and balance the loss.
  
• More stable returns: Your money may grow slowly but steadily over time.
  
• Covers many areas: You invest in different sectors, types of funds etc.
  
• Useful for long-term planning: You can match investments with short or long goals.
  
• Provides flexibility: Adjust your portfolio as per market conditions or changing financial goals.
  

Cons of diversification:

• Too many investments can be confusing: Handling many funds or stocks may become challenging.
• Returns may be average: Since gains in one asset are often balanced by losses in another out, the returns may be moderate.
• May cost more: Managing too many funds can involve higher fees like brokerage, charges, etc and effort.
• Overlap of assets: You may unknowingly invest in similar stocks through different funds.
• Harder to track performance: You’ll need more time and effort to review all your investments.

So, diversification is like having many baskets for your eggs. Even if one basket drops, your other eggs are safe. But if you have too many baskets, it becomes hard to carry them all. That’s why smart diversification is better than over-diversification.

Concentration of Investments

The concentration strategy means putting your money into just a few investment options instead of spreading it out. You focus on a small number of strong options that you believe will do well.

For example, instead of choosing 6 or 8 mutual funds, you might only pick 2 or 3. You may select a large-cap fund and a sectoral fund. If these funds do well, your money can grow very fast. But if they don’t, you might face loss as well.

This approach needs careful research and confidence.

Concentration within an asset class: An example

Let’s say you want to use the concentration strategy with equity mutual funds. Instead of choosing 8–10 different funds, you choose just 2 or 3 funds.

For example:

• A large-cap fund (covers major companies)
• A pharma sector fund (for healthcare growth)

You ensure that these funds don’t invest in the same stocks.. This lets you focus more on performance and worry less about duplication. If both these funds do well, your returns can grow .

The Pros and Cons of Concentration

Let’s look at the pros and cons of concentration:

Pros of concentration:

• High growth potential: If your investments do well, you can earn returns.
  
• Easy to manage: Fewer investments mean less time needed to track and update.
  
• Saves cost and time: Lower charges and effort in managing fewer funds.
  

Cons of concentration:

• High risk: If your investment fails, you can lose a part of your money.
  
• No safety net: With no backup, you can’t balance a loss from one with gains from another.
  
• Needs experience: This strategy is better for those who understand the market well.
  

In simple terms, concentration is like putting all your eggs in one or two baskets. If you know those baskets are strong, it might work well. But if they break, you lose all your eggs. It’s a strategy for people who are okay with higher risk.

The bottom line: Which approach wins in the long term?

In the long run, both diversification in investing and concentration strategy have their place. Sometimes, asset classes are already diversified, so putting your money in more asset classes might not add significant value.

A thoughtful approach to investing may begin with broad diversification to manage risk and explore opportunities across sectors or asset types. Overtime , based on the performance trends and evolving goals , one can gradually streamline their holdings.. The best path depends on your goals, comfort with risk, and how long you want to stay invested.

 

Summary

If you like safety and don’t want surprises, diversification can offer a balanced approach. It balances the risk and helps steady growth. If you are okay with taking some risk and want to aim for higher returns, the concentration strategy may work better. But it needs more research and attention.

Start simple, review your choices, and move to a strategy that suits your goals.

FAQs

Why is diversification important even if you have a long time horizon?

Even if you intend to remain invested for 10, 20 or 30 years, you will experience some ups and downs in the market. Certain investments may just not perform well occasionally. For instance, an established company may lose value, an industry that you are invested in may run into trouble, etc. Investing in a diversified manner will give you some protection from big losses since your money is dispersed across different assets. While one of your investments may be experiencing losses, another investment may be doing well. This will give your money time to grow steadily and safely, while providing peace of mind, even during market ups and downs.

What is a concentrated portfolio?

A concentrated portfolio means you put most of your money into just a few investments. This can sometimes give returns if those few options do very well. But it is also risky. If one of them performs badly, you can lose money. So, this strategy is only good if you understand what you are doing and are okay with more risk.

What investment strategy should I choose?

It depends on your comfort with risk. Concentration can give faster and higher growth if you pick the right options, but it can also lead to loss if the market doesn’t perform well . Diversification in investing, on the other hand, spreads your money out and keeps your overall risk lower. It may not always give high returns, but it helps protect your money. If you are not very experienced or don’t want surprises, diversification can be a balanced approach . Each strategy has its place, and the best one depends on your goals and risk taking ability.

Do diversified portfolios have high returns?

A diversified portfolio gives stable and steady returns by reducing risk. Your risk exposure reduces as your funds are distributed among numerous investment options because some investments will succeed, but others may not. Different investments help balance your fund growth as a whole. A concentrated portfolio may see faster growth, however, a diversified portfolio may provide stable returns.