Revathi Asset Management

Should you diversify?

In the classroom, students are told that diversification is the only free lunch in finance. The idea is that a portfolio of many stocks is more likely to produce better risk-adjusted returns than a single stock. There is too much idiosyncratic risk in a single stock or a highly concentrated basket of stocks. If even one stock underperforms by too large a margin, it becomes impossible to outperform or even match the market. Thus, the argument is that more is better, at least 20 as per studies, ideally 50 as per mutual fund managers, and maybe even 100+ in some cases like insurance funds.

Meanwhile, in practice, if you study the track record and advice of some of the most famous and best-performing fund managers, many of them take concentrated bets and openly advocate doing so. This is the “put all your eggs in one basket and watch that basket very carefully” side of the argument. It has its own merits. Why would you add stocks that you think are worse, just for the sake of being diversified? The job is to “hold companies that should perform well”, not to “hold many companies.” Besides, studies have also shown that in times of market stress, “correlations go to one” and diversification doesn’t provide downside protection when it’s needed most. So what’s a portfolio manager to do?

Small cap diversification

Let’s study the market by dividing it by market capitalisation. Looking at small caps first, we see a clear argument for diversification. The 250 stock index outperforms the 100 stock index, which outperforms the 50 stock index. This has happened consistently for the majority of the 19-20 years that we are looking at.

The logical explanation for this is that the average small cap stock will have much more idiosyncratic risk than the average large cap stock. Thus, as an investor, the best way to maintain long exposure to small caps is to own as many as possible, so that no single stock can make a significant dent in your portfolio should things go south. The risk-adjusted performance metrics clearly improve across the board as the diversification increases. The more diversified the small cap portfolio, the higher the return and the lower the max drawdown and volatility.

Mid cap diversification meets di-worse-ification

Moving on to the mid-caps, we see something similar (with the 150 stock index performing the best) but different (with the 50 stock index performing the worst). The 15-stock index performs in the middle. We extend the explanation of idiosyncratic risk from the small caps to the mid-caps, i.e. that diversification helps a midcap portfolio. Midcaps still carry too much idiosyncratic risk on average, so it’s best to have 150 of them.

For the second part of the analysis, we would say that the 15-stock index outperforms the 50 partly because the top 15 liquid mid-cap stocks are almost large caps themselves, so they don’t hold as much idiosyncratic risk as smaller companies. As a result, we are starting to see the trade-off between diversification and di-worse-ification here. The risk-adjusted metrics confirm what the charts show, with the 150 stock index clearly performing the best and the 50 stock index performing the worst. Across the board, 150 is best, 15 is second best, and 50 is worst.

Large cap di-worse-ification

Finally, looking at the large caps, we see a third perspective. The top 20 equal weight index performs the best. The Nifty 200 only recently and marginally outperforms the Nifty 50. If you look closely at the chart, the Nifty 50 outperformed the Nifty 200 from 2006 to 2024. As we had seen in an earlier chapter, the reason is likely that the diversification from 50 into 200 also brings in slightly smaller companies that have outperformed the Nifty 50 only since 2024. The recent bull run of 1 year has changed 14 to 15 years of history, as we had seen in the chapter on large caps versus mid caps.

The takeaway here is that diversification is not necessarily better for large caps. The current difference between the 200 and the 50 is not very significant anyway when we look at the risk-adjusted performance measures. This minor outperformance of the Nifty 200 over the Nifty 50 also seems to be reversing in real-time at the time of writing, so the jury is still out. Overall, we actually would be inclined to say that diversification is di-worse-ification in the case of large caps because the idiosyncratic risk is much lower than it is in small or mid caps. We are also seeing a higher max drawdown with only marginally better volatility risk metrics for the 200 vs the 50.

How will diversification affect you?

While this may have been a simple study, it shows that all diversification is not created equal. It can definitely add value to your portfolio depending on your mandate, but it is by no means a free lunch. It depends on the portfolio universe and your goals; you as a portfolio manager have to exercise judgment on whether to diversify or not.

What we are seeing here is that:

• Portfolio managers will face to tradeoff between diversification and di-worse-ification, depending on the stock universe.
• For small caps, diversification is recommended, likely due to concentration and idiosyncratic risk.
• For mid-caps, diversification is also recommended overall. More importantly, more diversification may be better than less .diversification, so either buy as many as you can or stick to a small group of the best mid-caps.
• Finally, for large caps, diversification is most likely di-worse-ification.