Diversity Moderately

Individual investors in India often have over diversified portfolios. Typically, they have 15 to 50 different shares in their portfolio. This may be mainly due to the following reasons: (1) Number of shares received at the time of public issue is often small. As a result, investors tend to have a large number of different shares in small quantities. (2) Investors perhaps feel psychologically secure with a large number of different shares in their portfolio. (3) There is reluctance on the part of investors to sell shares.

You must, however, realize that diversification beyond a certain point does not bring any appreciable gain in terms of risk reduction, which is usually the principal motivation for diversification. Empirical studies have provided reasonably conclusive evidence in support of the hypothesis that the bulk of the benefit from diversification, in the form of risk reduction, can be achieved by forming a portfolio of about 10 stocks; thereafter, the gains from diversification tend to be negligible.

In view of this relationship, you should normally plan to have about 10 stocks in your portfolio. If you have fewer stocks in your portfolio you may be unnecessarily exposed to risk which can be easily diversified away. The 10 to 12 stocks held by you should span at least 4 different industries with no single industry accounting for more than, say 40 percent of your investment.

If you have more stocks in your portfolio, transaction and monitoring costs tend to increase, without any worthwhile reduction in risk. More important, an overly diversified portfolio dilutes focus which in turn is likely to impair the quality of investment management. If you have 10 stocks in your portfolio, you are likely to be circumspect in your decision making and attentive in your monitoring, because each stock accounts for, on average, 10 percent of your portfolio value. On the other hand, if you have 50 stocks in your portfolio, you are likely to be cursory in your decision making and negligent in your monitoring because each stock accounts for, on average just 2 percent of your portfolio value.

Periodically Review and Revise the Portfolio:

Often investors do not review and revise their portfolios regularly. This may be due to a variety of reasons:

1. Lack of time and inclination to undertake periodic review and revision.
2. Sticky portfolio habits (many investors have a reluctance to sell securities because they are likened to gold or real estate to be liquidated only during a time of financial distress).
3. An adequate appreciation of the benefits of periodic review and revision.

Since the world of investments is highly dynamic and rapidly changing, it behooves upon every investor to periodically review his portfolio and revise it in the light of changed circumstances. Over time, several changes are likely to take place:

1. Relative market values of various securities in the portfolio tend to change.
2. New information may alter the risk return prospects of various securities.
3. Funds may be made available for portfolio investment; or funds may be required from the portfolio.
4. Investor disposition toward risk may itself change, albeit very gradually.

In order to cope with these changes, periodic review and revision is required to:

1. Maintain adequate diversification when relative values of various securities in the portfolio change;
2. Incorporate new information relevant for risk return assessment.
3. Expand or contract the size of portfolio to absorb funds or with draw funds; and
4. Reflect changes in investor risk disposition.

How often should the exercise of portfolio review and revision be undertaken? As this exercise entails monitoring costs, transaction costs, and taxes, its periodicity should be so fixed that its benefits are maximized in relation to its costs. This means that (1) if the investment environment is volatile, review be made more frequently, (2) if an active approach is followed review should be more frequent, and (3) if the size of the portfolio is large, review should be more frequent.

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