Diversifying your investments is vital for success, but having too much overlap in your portfolio can be risky. In this article, we’ll explore portfolio overlapping and its potential pitfalls. Plus, we’ll provide practical strategies to help you manage your investments wisely. By the end, you’ll be better equipped to safeguard your money and make smarter investment choices. Let’s get started!
The Context
When it comes to investing, diversification is the golden rule – and it’s preached by almost everyone in the game.
But here’s the catch: nobody seems to mention the shadowy side of diversification, which can lead to a dangerous pitfall called “Portfolio overlapping.” This sneaky situation arises when you unknowingly invest in the same stocks across different investments in your portfolio. And while it may seem harmless at first, it can send your portfolio’s performance plummeting faster than a skydiver without a parachute.
So, before you start stacking up on the most sought-after stocks, it’s crucial to know how to avoid this lurking danger. In this article, we will explore the risks associated with overlapping stocks and provide practical strategies to help you manage them.
Statistical Anecdotes
Studies have revealed that a considerable proportion of individual investors do not take an active role in managing their investment portfolios or adopting asset allocation strategies.
For instance, a 2020 survey by Scripbox, an Indian online investment platform, indicated that only 10% of respondents regularly review and rebalance their investment portfolios, while a staggering 45% said they never review their portfolios. Furthermore, the survey found that 64% of respondents had never even heard of the concept of asset allocation.
Another survey conducted by Bankrate U.S. in 2019 discovered that only 31% of Americans who invest in the stock market regularly adjust their asset allocation, while a significant 45% of respondents admitted they have never adjusted their allocation.
Moreover, according to a study by Vanguard U.S., investors who did not have the guidance of a financial advisor tended to have less diversified portfolios and were more prone to engage in detrimental market-timing behaviors, leading to lower long-term returns.
On the other hand, institutional investors like pension funds, endowments, and insurance companies have specialized investment teams that proactively manage their portfolios and implement advanced asset allocation strategies tailored to their specific products. However, the issue arises when retail investors attempt to buy multiple products to cherry-pick the best from the market.
Exposure Ignorance
Have you ever heard of exposure ignorance?
We have discovered that some self-directed investors may be unknowingly succumbing to this ambiguous investing pitfall and here’s why.
If you happen to be an Indian investor who has a preference for large-cap mutual funds, it is crucial to understand that several of these funds tend to have similar top holdings. This phenomenon can be attributed to regulatory limitations and is occasionally influenced by the fund managers’ favorable bias.
The top holdings typically include some of India’s most prominent companies such as HDFC Bank Ltd, ICICI Bank Ltd, Infosys Ltd, Reliance Industries Ltd, and State Bank of India. These companies have a market capitalization of more than Rs 20,000 crore and are among the top 100 in market capitalization. Furthermore, it’s crucial to be aware that the financial sector is the most common in most Indian large-cap mutual funds, with the technology and energy sectors following suit.
While the average percentage exposure to the financial sector may vary across different funds, our research indicates it could be around 25-30% of the total portfolio. The technology and energy sectors could have around 10-15% exposure each. But here’s where it gets tricky: let’s say you also want to take matters into your own hands and pick some stocks for your portfolio, without considering how much exposure you already have to those same stocks through your passive mutual fund investments.
As you embark on your journey of handpicking stocks, you dive deep into the world of research, seeking out hidden gems that others might have missed. You pore over financial statements, news articles, and market trends, determined to find the next big thing. And finally, after hours of diligent work, you stumble upon some excellent stocks like HDFC Bank, ICICI Bank, or Infosys Ltd again which seems like a surefire way to make a profit.
Now, if you do not pay attention to how much exposure you already have to these stocks through your mutual fund investments, your portfolio could become a ticking time bomb, ready to explode at any moment. You might end up unknowingly overexposed to the same stocks through your mutual fund investments, putting your financial future in jeopardy.
This is a trap that can also catch you when investing in mid-cap, small-cap, or thematic mutual funds.
The Looming Risks
One of the most significant dangers of having overlapping stocks is concentration risk. If a large proportion of your portfolio is invested in only a few stocks or sectors, then the overall performance of your portfolio will be impacted severely if those stocks or sectors underperform.
Another risk of overlapping stocks is the duplication of fees. If you invest in several mutual funds or ETFs that hold the same stocks, you may end up paying multiple sets of fees for the same underlying stocks. This could eat into your returns and diminish the overall performance of your portfolio.
To minimize risks associated with overlapping stocks, it’s best to follow the rule of thumb of not having more than 14% of your portfolio in a single stock or more than 25% in a specific sector. It is recommended to strictly follow these guidelines to avoid significant losses in the long run. In case of any doubts, it is advisable to seek guidance from a registered financial advisor for further information.
Strategies to Manage Overlapping Stocks
To manage the risks associated with overlapping stocks, consider implementing the following strategies:
≡ Regular Reviews
Reviewing your portfolio regularly can help you identify any overlapping stocks and take action to reduce your risk. Consider using a portfolio tracking tool like “ET Money” to simplify the process.
≡ Diversify Across Assets
To mitigate concentration risk, it is advisable to diversify across asset classes. This can be achieved by investing in a mix of uncorrelated stocks, mutual funds, and ETFs, as well as other asset classes such as bonds and commodities. By adding a variety of investments to your portfolio, you can reduce the risk of being heavily reliant on a single stock or sector.
≡ Find Non-overlapping Investments
When selecting investments, look for options that do not hold the same stocks. For example, instead of investing in two mutual funds that hold the same stocks, consider investing in one mutual fund that offers exposure to different stocks.
≡ Keep It Simple
Low-cost index funds are a great option for most novice investors who want to avoid overlapping stocks and reduce fees. Equity traded funds are pretty much no-brainers and track a specific index, such as NIFTY 50, and offer exposure to a broad range of stocks at a low cost.
Conclusion
To sum up, it is important to pay attention to overlapping stocks in your investment portfolio to avoid concentration risk and duplication of fees. As discussed earlier, many individual investors tend to overlook these risks and do not actively manage their portfolios or engage in asset allocation strategies. To mitigate these risks, you should review your portfolios regularly, diversify across asset classes, deliberately seek out non-overlapping investments, and consider low-cost index funds to keep it simple.
By adopting these strategies, you can build a well-diversified portfolio that aligns with your investment goals while minimizing potential risks. Overall, proactive management and diversification are key to achieving long-term investment success.
We appreciate your time and hope you found this post useful.
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1 Comment
Usually, I don’t really drop comments on blog posts, but this one caught my attention big time. It’s the kind of knowledge that you just won’t find on YouTube!