What Is Overdiversification of Portfolio? Why Should You Avoid It?

Introduction

In India’s dynamic investment landscape, more is not always better. While spreading risk matters, there’s a tipping point where diversification becomes counterproductive. This blog post unpacks the idea of overdiversification of portfolio, explains why it’s a hidden risk for Indian investors and shows how to build a portfolio that truly aligns with your goals.

Understanding the Concept of Overdiversification of Portfolio

Diversification is a core investment concept: allocating money across different assets, sectors, geographies, and asset classes to reduce unsystematic risk. However, when you diversify excessively, that is, investing in too many holdings or overlapping funds that each one has a negligible impact, you face the risk of overdiversification of portfolio.

To keep it simple, you dilute your returns, complicate management, and may end up with a portfolio that behaves like a replica of the market index rather than one built for your aims. For Indian investors, this means that simply investing in a large number of mutual funds, stocks, or asset-classes does not automatically yield benefit, especially if many holdings overlap in sector, stock or strategy.

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Why Does Overdiversification of Portfolio Happen in India?

1. Over‐enthusiasm and Fear of Missing Out

Many first-time or retail investors in India build portfolios by chasing ‘variety’, buying multiple mutual funds, stocks, gold, and international exposure, thinking more means safer. But that’s a key cause of overdiversification of portfolio.

2. Multiple Similar Funds

Investors often hold 5-10 equity mutual funds from different AMCs, but many of these funds invest in the same top stocks (e.g., the large-cap names in India). That creates overlap and little real diversification.

3. Too Many Asset Classes without Strategy

In trying to cover everything, equity, debt, mix, gold, real estate, international- investors may lose focus on their core goal, leading to a portfolio that is hard to manage.

4. Lack of Periodic Review

With a large number of holdings, tracking performance and rebalancing become challenging. Over time, drift and complexity lead to overdiversification of portfolio.

5. Indian Mutual Fund Market Particularities

In the Indian mutual fund context, large-cap funds often hold the same stocks; sector funds overlap; and adding more funds may simply duplicate underlying holdings rather than broaden exposure.

Why Should You Avoid Overdiversification of a Portfolio

Dilution of Potential Returns

When you own too many investments, each holding becomes too small to make a real difference if it performs well. The upside potential is averaged out across many average performers.

Hidden Overlap and Illusion of Diversification

You might feel diversified, but if many holdings correlate (e.g., the same large-cap stocks across funds), you are exposed to similar risks. Your portfolio then fails to deliver the benefit of true diversification.

Increased Complexity and Higher Costs

More holdings mean more difficulty in tracking, more fees (mutual fund expense ratios, transactional costs) and more time spent on analysing. For Indian investors this can be a drag on net returns.

Behavioural and Management Risks

With a large, unwieldy portfolio, rebalancing appropriately becomes harder. Drift in allocations may increase risk unintentionally. Also, decision-making may become less focused.

Portfolio Becomes “Index-like” and Loses Edge

When you own so many stocks or funds that your portfolio effectively mirrors the broader market index, you are paying for active management (if applicable) but getting index returns. That’s one symptom of overdiversification of portfolio.

How to Recognise When Your Portfolio Is Overdiversified

Here are practical signals Indian investors can look for:

• You hold more than, say, 10-15 equity mutual funds (plus debt, etc) and cannot clearly articulate how each fits.
  
• You see the same top 10 stocks repeated across multiple funds in your portfolio. Tools show high overlap.
  
• Your returns are mediocre and you feel your portfolio is “busy but flat”. For example, an article noted that one investor held 10 equity funds + 7 debt funds + others but still got average results.
  
• You spend a lot of time trying to keep track of many holdings and feel the portfolio is complex to manage.
  
• You don’t feel any individual holding has meaningful weight to move the needle.
  
• You cannot clearly define your asset allocation, risk budget, or goal-linking for each holding.
  

Smart Strategies to Avoid Overdiversification of Portfolio

Clarify Your Investment Goals, Time Horizon & Risk Appetite

Before adding many holdings, ask: “What am I investing for? How long do I have? What risk can I tolerate?” A clear framework helps decide how many holdings make sense.

Adopt a Structured Asset‐Allocation Framework

In India, this means allocating across asset classes (equity, debt, gold, maybe international), and then within equity across styles (large-cap, mid-cap, flexi-cap) rather than buying many funds in the same category.

Limit Number of Funds / Holdings with Purpose

Rather than owning many funds, go for a smaller number of well-researched ones that cover distinct strategies. For example: one large-cap equity fund, one mid-cap, one debt, one gold, one international. References suggest that more than 3-4 equity funds may be unnecessary.

Check for Underlying Overlap

Use fund fact-sheets and overlap‐tools to see whether multiple funds hold the same stocks. If overlap is 40-50% or more, you might be overdiversified.

Regular Portfolio Review and Rebalancing

At least once in a year, review your holdings: Are they still aligned with your goals? Are allocations drifting? Are any small and under-performing holdings dragging you? If yes, simplify or exit.

Focus on Quality and Conviction

Better to hold fewer high conviction holdings/exposures than many “weak” ones simply for the sake of variety. In India, that might translate to carefully picking sectors or funds that add value rather than selecting many for “just in case”.

Make Costs Count

Every additional fund or stock adds costs (time, fees, taxes). If the marginal benefit of adding a holding is low, don’t add it. This mindset helps avoid overdiversification of portfolio.

Maintain Simplicity

A portfolio that you understand and can manage easily is better than one with many overlapping layers. For most Indian retail investors, a simpler, goal-linked and reviewed portfolio works well.

Key Takeaways

• Overdiversification of portfolio happens when the number or type of holdings grows beyond what adds incremental benefit and instead dilutes returns, increases cost and complexity.
  
• In the Indian investment context it often arises through holding many mutual funds or asset classes without checking overlap or strategic fit.
  
• The main risks of overdiversification of portfolio are dilution of returns, hidden overlapping risk, increased complexity, and losing alignment with investment goals.
  
• Recognise the warning signs: too many holdings, repeated stocks across funds, average returns, tracking difficulties.
  
• To avoid it: set clear goals; structure allocation; pick fewer, distinct funds/holdings; check overlap; review periodically; focus on conviction and simplicity.
  
• Simplicity, clarity and strategic focus often beat chasing “many” exposures. Let diversification be purposeful, not passive.
  
• Ultimately, you don’t diversify to diversify. You diversify to improve risk-adjusted outcomes. Excess doesn’t help. As one commentary noted: “Diversification is like ice-cream. It’s good, but only in moderation.”