Are You Overdiversifying? The Hidden Risks of Too Many Index Funds for Indian Investors

Are you riding the wave of index funds? If you’re like many Indian investors these days, chances are your investment portfolio has at least a few of these popular funds. And honestly, for good reason! Index funds are awesome because they’re usually cheap, super easy to buy and sell, and they help you spread your money around without much effort.

But here’s a thought that might surprise you: Can you actually have too much of a good thing, even with index funds? It sounds weird, right? We’re always told to diversify, diversify, diversify! However, there’s a sneaky little trap called overdiversification index funds, especially when it comes to stuffing your portfolio with too many of them. This can actually bring hidden risks and, believe it or not, even lower your returns.

So, if you’ve been wondering whether your collection of index funds is truly working as hard as it could be, or if you’re just accidentally making things more complicated, you’re in the right place! Let’s chat about what overdiversification really means, why it’s a problem, and how you can keep your portfolio smart, simple, and effective.

What Exactly is “Overdiversification”?

You know how everyone talks about diversification? It’s like not putting all your eggs in one basket. If one egg breaks, you still have others! Diversification in investing means spreading your money across different assets to reduce risk. If one investment doesn’t do well, others might pick up the slack.

But overdiversification happens when you go a bit overboard. It’s when you add so many different investments or funds to your portfolio that it actually stops helping you. Instead of making you safer or giving you better returns, it just makes things messy and can even pull your returns down. Think of it as having so many different kinds of fruits in your basket that you can’t even taste the good ones anymore!

The Rise of Index Funds in India: And Why We Love Them!

Before we talk about the downsides of too many, let’s appreciate why index funds became so popular in India. They really have changed the game for many investors!

• Low Costs: Index funds usually have very low fees (called ‘expense ratios’) because they simply copy a market index (like Nifty 50) instead of having a fund manager actively pick stocks. This means more of your money stays invested!
• Transparency: You always know what you own because they mirror a public index. No hidden surprises!
• Market Returns: They aim to match the market’s performance, so you don’t have to worry about whether your fund manager is doing better or worse than the overall market.
• Broad Exposure: They offer an easy way to get a slice of the entire market, like buying a bit of all the top companies in India.

This appeal has led to a huge boom! Just look at the numbers: the total number of retail index fund accounts (called ‘folios’) in India grew almost 12 times, jumping from 4.96 lakh in March 2020 to a massive 59.37 lakh by December 2023! (Source: Zerodha Fund House). That’s a lot of folks getting into index funds! They’re often seen as the perfect core for any well-balanced investment portfolio.

Also Read :- Goal-Based Financial Planning: Your Personal Roadmap to Financial Freedom

The “Too Much of a Good Thing” Problem: Hidden Risks of Overdiversification

Now for the tricky part. While index funds are great, piling on too many can actually create problems you might not even realize.

1. Your Returns Start to Shrink (Diminishing Returns)

Imagine you’ve added 5 or 6 different types of investments to your basket, and your risk is looking good. But then you add another 5 or 6, and another 5 or 6, thinking it will make you even safer. Here’s the catch: after a certain point, adding more index funds (especially if they’re similar) doesn’t really lower your risk much further. Instead, it spreads your money so thin that you might miss out on bigger gains from your best-performing assets. Your capital gets diluted, and your overall portfolio’s growth can actually slow down (Source: Bajaj Finserv AMC). It’s like adding too much water to a strong juice – it just gets weaker.

2. More Funds, More Headaches (Increased Complexity)

You bought index funds because they’re supposed to be simple, right? But if you start owning 10, 15, or even 20 different index funds, suddenly your portfolio isn’t so simple anymore! You’re trying to keep track of various fund names, understand tiny differences between them, and figure out which ones are actually doing what. This extra effort can become a real burden and might even lead to you making mistakes or missing good opportunities because you’re lost in the details (Source: Groww). Simplicity is key for long-term investing!

3. Thinking You’re Diversified, But You’re Not (Overlapping Investments)

This is a big one! Many investors accidentally own multiple index funds that are practically the same. For example, if you own both a Nifty 50 index fund and a Sensex index fund, you’re not getting much extra diversification. Why? Because both these indices are heavily made up of very similar large-cap stocks (Source: Groww). You end up with a “false sense of security” because your money is actually concentrated in the same big companies across different funds. If those few big companies face problems, your entire portfolio could still take a hit.

4. The Costs Add Up (Higher Costs and Lower Efficiency)

Even though index funds are famous for being cheap, every single fund you own comes with its own small expense ratio. If you have too many, these small fees start adding up! Plus, there might be tiny transaction costs every time you buy or sell. When you’re just getting redundant exposure (like having two funds that essentially hold the same stocks), those extra fees are just eating into your returns for no real benefit (Source: Bajaj Finserv AMC). Keep it lean to keep more of your money working for you.

5. Big Fish in Small Ponds (Concentration Risks Within Index Funds)

Here’s another point to consider: Even a single, well-known index fund can have “concentration risk.” What does that mean? It means the top few companies in that index might make up a very large portion of the fund. For instance, some of the top stocks in the Nifty 50 or Sensex can have significant “weights” – sometimes over 10% in just one stock! (Source: PrimeInvestor). Our market regulator, SEBI, has set limits on this, but the risk of being heavily reliant on a few big names within an index still exists. So, if you own several index funds that all have similar top-heavy holdings, you’re not really solving this concentration problem; you’re just multiplying it!

6. The “Wobble” Effect (Tracking Error)

Index funds try their best to perfectly copy the index they follow. But sometimes, they don’t quite get it right. The difference between how much the fund returns and how much the actual index returns is called “tracking error.” This “wobble” can happen due to fees, cash holdings, or other factors. Research shows that in India, index mutual funds have sometimes had higher tracking errors compared to ETFs (which often track their indices a bit more closely) (Source: Vidyaprabodhini College & IJRTI). While often small, these tracking errors, especially across many funds, can quietly chip away at the returns you were expecting.

Also Read :- Index Investing: The Smartest Way to Build Wealth Without the Stress

How to Be Smart and Avoid Overdiversification with Index Funds

Don’t worry, it’s not all doom and gloom! Index funds are still fantastic tools. The trick is to use them wisely. Here’s how you can avoid overdiversification and build a smarter portfolio:

1. Focus on Your Core: Pick one (maybe two, at most) broad-based index fund as the main foundation of your stock investments. A Nifty 50 index fund is a great starting point, giving you exposure to India’s top companies without needing a hundred other funds (Source: Business Today).
2. Be Picky with Sector Funds: Only add sector-specific (like a banking index fund) or “thematic” index funds (like a technology index fund) if you really know what you’re doing, understand the extra risk, and have a strong, long-term reason to believe that specific sector will do well. Don’t just add them because they sound cool!
3. Check for Overlaps (Do Your Homework!): Before you buy a new index fund, take a few minutes to check its top holdings. Are they mostly the same companies as your other funds? If yes, you might be just adding redundancy instead of true diversification. Many financial websites or fund analysis tools can help you compare.
4. Diversify Beyond Stocks: True diversification isn’t just about having many stock index funds. It’s about spreading your money across different types of investments, or “asset classes.” Think about adding index funds for:
   • Bonds/Debt: To add stability to your portfolio.
   • International Equities: To invest in companies outside India and reduce your reliance on just the Indian market. For example, a global index fund. (Source: Business Today).
5. Keep It Simple, Stupid (KISS Principle): The fewer funds you have, the easier it is to manage, track, and keep costs low. A simple portfolio is often an effective portfolio.

Key Takeaways for Indian Investors

Let’s quickly recap the main points about overdiversification in index funds:

• Having too many index funds is a real issue and can actually hurt your investment returns.
• Just owning lots of index funds that track similar market parts won’t give you extra risk reduction.
• Remember that even big index funds can have a lot of money tied up in a few top companies.
• Your goal should be a simple, cost-effective portfolio that spreads your money smartly across different types of investments, not just more of the same.

Also Read :- 5 Vital Pillars to Build a Stable Financial Life

Conclusion: Quality Over Quantity in Diversification

In the world of investing, the old saying “quality over quantity” truly applies, especially when it comes to overdiversification in index funds. While index funds are powerful tools for wealth creation in India, simply adding more and more to your portfolio beyond a certain point can be counterproductive.

The goal of diversification is to reduce risk and enhance returns, but going overboard can dilute your gains, add unnecessary complexity, and even create a false sense of security due to overlapping investments. By understanding these hidden risks, being mindful of your holdings, and diversifying across genuine asset classes (like stocks, bonds, and international markets), you can build a robust, efficient, and truly diversified portfolio.

So, take a moment to look at your investment basket. Is it smart and lean, or is it getting a bit too cluttered? A focused, well-thought-out approach to diversification will ultimately serve your financial goals much better than simply piling on more funds. Happy investing!

FAQs (Frequently Asked Questions)

1. What is overdiversification in the context of index funds?
   • It’s when you have too many index funds in your portfolio, especially those tracking similar markets, which can actually reduce your returns and make managing your investments harder instead of making you safer.
2. Why should I avoid having too many index funds?
   • Too many similar index funds can lead to diminishing returns, unexpected higher costs, make your portfolio complex, and result in investing in the same companies repeatedly (overlapping investments).
3. Do Nifty 50 and Sensex index funds offer true diversification from each other?
   • Not significantly. Both Nifty 50 and Sensex are dominated by similar large Indian companies, so owning both may lead to overlapping investments rather than true diversification.
4. How can I effectively diversify my investment portfolio?
   • Focus on a few core broad-based index funds, diversify across different types of assets (like stocks, bonds, and international investments), and regularly check for overlapping holdings.
5. What is “tracking error” in index funds?
   • Tracking error is the difference between an index fund’s returns and the returns of the actual index it’s supposed to follow. It can slightly reduce your expected returns over time.