The dose makes the poison

I think it was Charlie Munger who, during a recent Berkshire annual shareholder's meeting, used the word 'diworsification', originally coined by Peter Lynch in his book 'One Up in Wall Street'. Someone once called Munger the world's richest stand-up comedian, and I must say that his use of the word incorporates not just wit but a great deal of investing wisdom.

This is what Charlie Munger said, "A lot of people think if they have 100 stocks, they're investing more professionally than they are if they have four or five. I regard this as insanity. Absolute insanity. I think it's much easier to find five than it is to find 100. I think the people who argue for all this diversification, by the way, I call it 'diworsification,' which I copied from somebody. And I'm way more comfortable owning two or three stocks which I think I know something about and where I think I have an advantage."

While he was talking about stocks, here we are talking about mutual funds, but the principle applies just as well. When people set out to invest 'properly', they feel that diversification is the most important thing. This is correct, of course. However, every child has heard the saying, 'Don't put all your eggs in one basket'. In the world of investing, this translates to diversification - a concept universally recognised as advantageous by investors. Those investing in mutual funds commonly interpret this as a need to spread their investments across multiple funds instead of sticking to one or two.

Consequently, they determine that investing in two funds outperforms one, three surpasses two, and so on. But when does this trend reach its limit? Is the tenth fund superior to the ninth? What about the twentieth? Or even the fiftieth or hundredth? Eventually, diversification reaches a point of diminishing returns, where it no longer adds value, then becomes counterproductive and, ultimately, absurd.

I have long observed that amongst Indian mutual fund investors, diworsification and not a lack of diversification is the most common problem. The reason is not far to find. For decades now, the hard-driven sales process of mutual funds has been structured so that the industry itself - the sellers and the AMCs - find it most profitable to sell new funds and keep selling them in greater and greater numbers. Recently, our research team ran some numbers to understand the extent of the problem.

Investors believe they can attain diversification by placing their money in many funds. This is, of course, true. However, beyond a point, adding more funds does not enhance diversification. Mutual funds are not standalone investments but vehicles for holding the underlying assets, which are stocks for equity funds. Over-diversification is ineffective primarily because similar funds tend to hold similar or identical stocks. Hence, once a certain number of funds are in play, additional funds typically introduce more of the same or similar stocks already present in the portfolio.

However, if the only downside of diworsification was that your returns became lower, one could take it as a mistake but not a terrible one. In practice, from what I've seen, the far bigger problem is what Charlie Munger is pointing at: You simply cannot know the time and the mental bandwidth to manage an oversized portfolio properly. If you have 20-30 or more funds, I can practically guarantee that many of them are not doing well, are not suitable for your financial goals and could be replaced by better ones. Moreover, such portfolios usually have a bunch of funds where you have tiny holdings that are irrelevant but lying there.

If this is you, then what you need is Diwali. I mean, not the festival itself but the house cleaning that precedes it. Clean out all the garbage and focus on what you need. If I've convinced you, then how do you start doing it? As I'm now fond of saying, that's where Value Research Premium comes in! We have the easiest way to solve your problem.

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