Construct Portfolio In Market Volatility

 Under-diversification is risky since a few slip-ups or a run-in with Bad Luck might prove to be portfolio-ending.

The mutual fund sector is the opposite extreme, where it is typical to see portfolios containing hundreds of stocks (I am generalizing). There are a variety of causes behind it. An army of analysts work for mutual funds; they must be kept occupied, their opinions must be heard, and their stock recommendations must be included in the portfolio (there are a lot of internal politics in this portfolio). Since these portfolios are constructed using benchmarks, they begin to resemble Noah's Ark by include a few animals (stocks) from each industry. Additionally, the fund's size could make it harder for it to purchase significant stakes in fledgling businesses.

This strategy comes with a number of drawbacks. First, and most importantly, it fosters apathy because it has no effect on the portfolio if a 0.5% stake doubles or is cut in half. The second issue is that it is hard to continue researching all of these viewpoints. Yes, a mutual fund will have a large staff of analysts tracking each sector, but the portfolio manager is the one who ultimately decides what to purchase and sell. Third, in a market where strong ideas are hard to come by, the 75th concept is probably not as good as the 30th.

Next, there are index funds. Although they appear to be excessively diverse, managed funds do not experience the problems associated with excessive diversity. In actuality, index funds have an uneven level of diversification. Take the most well-known of the group, the S&P 500. The 500 biggest US corporations are owned by it. You'd assume it was a portfolio that was well-diversified. Okay, sort of. More than 25% of the index is made up of the top eight firms. Additionally, because the index is market-cap weighted, it favours firms that are typically more expensive or that have recently risen. As a result, you are “diversified" among several overpriced stocks.

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