Look at your portfolio. Do you hold more than five equity funds or carry fixed deposits in more than five banks?

If so, you are probably suffering from compulsive diversification disorder! In this article, we ask a fundamental question: Do you really diversify? If so, how?

Diversification is a process where you hold investments that do not all decline at the same time.

In an ideal world, this means you should create a portfolio that has weakly-correlated assets. So, if one investment declines significantly, another will fall only marginally or move higher.

But in the globalised world, it is difficult to create such a portfolio, as all assets are often strongly correlated to each other. In such a situation, the best you can do is to create a portfolio with assets that do not all decline by a large amount at the same time.

Yet, that is what happens in a global crisis in 2008.

Why? In such times, all asset classes tend to move closely, as investors run for safety. That is why gold typically moves up during global crisis; as it is considered a "safe asset" during financial crisis.

True diversification requires that you analyse each additional investment in the context of the total portfolio.

So, if you want to buy a large-cap equity fund, you have to first analyse whether the fund has weak relationship with your existing portfolio of funds. But is that practical? Often, you tend to choose each investment in isolation based on its individual merits.

So, your portfolio is just an accidental composition of several funds bought at different points in time without regard to how they react with each other when markets decline.

In essence, while most of us talk about diversified portfolio, few of us actually create one!

To create your personal portfolio, it is not practical to diversify using statistical measures. You should follow a simple rule to engage in macro diversification (across asset classes) and micro diversification (within each asset class). As a first step, select three asset classes — equity, bonds and commodity (read gold). To diversify within equity as an asset class, do not buy several equity funds. Instead, choose not more than three strategies and styles that you want to invest.

This is your primary diversification process within equity. Then, decide whether to buy an active fund or index fund for each style and strategy. Do not buy more than one fund for each style and strategy. For instance, you may choose to buy a large-cap index fund, a mid-cap active fund and an arbitrage fund. Remember, your objective is to reduce market risk by diversifying your equity investments.

As for bonds, invest in tax-free bond issues and in not more than four bank fixed deposits. You can also maintain a public provident fund account as part of your retirement portfolio.

Finally, your investment in gold can be in a single gold ETF. Why? All gold ETF carry the same underlying (24-carat gold) and generate the similar returns. Moreover, gold ETFs do not have credit risk. So, why buy more than one gold ETF?

Finally, remember this: Buying a diversified fund does not make your portfolio more diversified! Neither does buying funds from several mutual fund companies.