The question whether midcaps or large caps should be viewed in terms of the time an investor is willing to hold onto his portfolio. For shorter durations of time midcaps will fluctuate wildly falling 40% with the market but when that happens investors forget that this stock also rose 40% with the market.

A risk taking investor should always invest in midcaps because it defines the scope of companies that can grow faster, quicker and longer. A large cap generally indicates a mature or a maturing business where the risks are limited but so is the opportunity for growth. A few points should be noted while investing in midcaps:

1) They should be sector leaders

2) Their financials should be strong.

In case these two conditions are met I do not think that there could be a problem in choosing between a midcap and a large cap. Finally as we said midcaps rise equally as fast as they fall so while they would be subject to higher volatility we cannot say that the chances of losing money is higher. That is as long as we have a long term view. Which in any case is a a sine-quo-non for investing in equities as a class.

A diversified portfolio tells you two things. One is, your standards are falling. Or the other thing, the markets are incredibly cheap. So yes that itself gives you discipline. If you are finding it incredibly difficult finding your dozen good ideas, again it tells you that either your standards are way too high, so you are an academic or the market is probably overvalued at this point – Vinod Sethi Former Fund Manager at Morgan Stanley

Now why diversification is important:

1)     It cuts down volatility. Lower volatility would lead to a higher Sharpe ratio. This ratio is sued by most of the fund mutual fund analysts to determine which fund is good. The best performing fund on the basis of Sharpe ratio hold over 100 stocks.

2)      There will always be a cause for celebration because some sector will always outperform. So the portfolio will never underperform the market.

3)      Event risks are cut down that means if a mutual fund is holding WIPRO and if WIPRO issues a profit warning with a 50% fall in price the fund that has diversified itself through a lot of companies would not get impacted since each company constitutes a very small percentage of its portfolio.

What are the pitfalls of diversification?

1)     I think that a person who diversifies into more then 25- 30 stocks is unsure of the stocks that he holds.

2)      Now if some one asks us what is the best large cap software company we would say Infosys. But a portfolio that is diversified will have Satyam and Wipro because the fund manager says what if Infosys does not do well. We could ask the same question what if Infosys does as well as we thought and Satyam underperforms. Diversification allows the weeds to get into our flower garden.

3)      Most of the times people who hold diversified portfolios want to have a bit of every rally in the market. In the example that you gave about Sundaram Select fund holding 194 stocks assume that the fund held an average bet of 0.5% in each stock. If it gets a ten bagger the portfolio moves by only 4.5%. Seasoned investors would know how hard it is to get a ten bagger and having got one it has made minimal impact to the NAV of the fund.

4)      The story does not end there as soon as the stock starts moving the manager will sell out to book profits because otherwise this stock’s weightage shall increase in his portfolio casing a shift away from the diversification mantra.

5)     Buffet preferred to hold a concentrated portfolio. At one point in time he had put half of his corpus to a single stock “American Express”.

6)     Mutual fund managers have quite a few problems a) they have a higher impact cost b) they need to keep their Sharpe ratio high c) Investors are mostly worried with wild NAV swings and therefore managers want to control volatility.

7)     Peter lynch the best fund manager of all times held over 1400 stocks in his fund but said that as a fund manager he had no option. On the number of stocks one should have in his portfolio he said

” Owning stocks is like having children – don’t get involved with more than you can handle. The part- time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any one time.”

The Robert Hag storm Study Results of Concentration

STEP – 1 The Different Sample Size

Computer randomly assigns from 1200 companies, 12000 portfolios of various sizes. For 10 year returns:

3000 portfolios covering 250 stocks each.

3000 portfolios covering 100 stocks each.

3000 portfolios covering 50 stocks each.

3000 portfolios covering 15 stocks each

Step 2 Result of the analysis

                    The Final Answer

Study 2:

In study it was indicated that the market risks reduces with an in crease in the number of stocks in the portfolio but only to a certain extent.

So increasing the number of stocks beyond a point (8 stocks) does not significantly reduce the market risk.