Let's begin by visualizing a scenario.
Suppose, you are going on a road trip and as a part of the preparation you buy a subscription of two bollywood playlist of 10 songs each. You plan to listen to the variety of songs as you have 20 songs in your collection now.
Cut to the highway. You are in the car and you open up the app to play some amazing songs.
Oops. wait.
What did you notice? Almost 80% of the songs in the two playlists were the same.
Oh no! Your dreams of listening to the varied playlist is shattered. You are in pain and remorse.
Okay, okay. Enough of this melodramatic behaviour.
But you get the point, right?
This is what happens in portfolio overlapping.
What is portfolio overlapping?
Portfolio overlapping refers to the circumstance where an investor invests in two or more schemes within a category and is likely to have the same stocks in their portfolio. This occurs when the majority of your mutual funds repeatedly invest in stocks that are comparable within the same or different categories.
The fundamental concept behind diversification is to invest in a variety of assets to reduce the risk attached to one single asset. Your goal of diversity and return maximization will be undermined if all or the majority of your funds are invested in the same stocks or businesses.
How to avoid portfolio overlapping?
First: Compare your mutual fund schemes and find out how exposed they are to various sectors. You should reevaluate your investment weighting if you discover that two or more of the funds in your portfolio have similar sectoral allocations or if the net allocation to a certain sector is particularly high.
Second: Optimal diversification is required to reduce the portfolio's risk. Align your investments with your goals, level of risk tolerance, and time horizon for making investments in order to get the best possible diversity. Aim to add no more than one or two schemes per category. This will enable you to keep track of how well the plans are working toward your objectives.
Third: Eliminate the scheme that routinely performs below its benchmark and the category average if you have added many schemes to the same category. The earnings from the scheme may be put toward other, more successful schemes. However, don't base your choice entirely on short-term assessments.
Fourth: Each fund house has a distinct culture that all of its fund managers adhere to. The fund managers of a specific fund company might invest in similar companies or industries or adopt similar strategies. Therefore, avoid purchasing multiple funds from the same fund provider. To ensure that your portfolio is well-rounded, invest across different fund houses.
It is advisable to check your portfolio from time to time to verify if the mutual fund overlap is not excessive and is positioned to help you reach your objectives. When you analyse the portfolio, determine whether it's necessary to replace the underperforming schemes with ones that are more appropriate.
