Diversification of Investment

“Don’t put all your eggs in one basket”, goes the old adage. Based on your goals you may have allocated your investment into various asset classes such as equities, fixed income, insurance and commodities. But if you do not diversify within each asset class, the exercise, according to analysts, is sub-optimal.

Spreading your fixed income investments is fairly simple but in the case of equities you need the right permutations and combinations of different stocks or equity funds to ensure that your portfolio sufficiently straddles good sectors and stocks.

The Benefits of Diversification

The benefit of diversification in your investments is to minimize the risk of a bad event taking out your entire portfolio. When you keep a high percentage of your portfolio in a single type of investment, you risk losing it if that investment sours.

The benefits of diversification include:

• Minimizes the risk of loss to your overall portfolio.
• Exposes you to more opportunities for return.
• Safeguards you against adverse market cycles.
• Reduces volatility.

How much to be Diversified?

Diversification within equities helps to reduce the volatility of the portfolio as well as protects against big losses from improper selection of stocks. Investors either end up with too little or too much diversification. You are inadequately diversified when you invest a large sum in a single stock, a handful of stocks or in a sector-specific mutual fund.

Sectoral funds typically come into favor for a short period and then lose steam. This can result in huge losses for the investors and sleepless nights.

And then there are investors who are over-diversified. These investors end up buying units of some 20 different diversified mutual fund schemes. This could mean double-diversification as one diversified fund alone gives you exposure to as many as up to 50 stocks-or prefer to invest small sums in stocks of hundreds of companies. The more the number of companies and mutual fund schemes one is invested in, more will be the time and effort required to monitor those investments.

Why Diversification of Investment Portfolio is necessary?

Diversification allows you to invest across asset classes, sectors, market capitalization, themes, which enable a balanced risk reward ratio. The general thumb rule for optimal diversification, according to portfolio managers, is a holding of 20-30 stocks or investment in five to ten mutual funds across various themes.

Portfolio Diversification

Portfolio diversification concerns with the inclusion of different investment vehicles with a variety of features. However, the strategy can bring benefits to an investor only if the investments included in the portfolio include a small correlation with each other. A small correlation indicates that the prices of the investments are not likely to move in one direction.

There is no consensus regarding the perfect amount of the diversification. In theory, an investor may continue diversifying his/her portfolio if there are available investments in the market that are not perfectly correlated with other investments in the portfolio.

An investor should consider diversifying his/her portfolio based on the following specifications:

Types of Investments: Include different asset classes such as cash, stocks, bonds, ETFs, options, etc.

Risk levels: The portfolio generally should consist of the investments with minimal levels of risk. Investments with dissimilar levels of risks allow the smoothing of the gains and losses.

Industries: Invest in companies from distinct industries. The stocks of companies operating in different industries tend to show a lower correlation with each other.

Foreign Markets: An investor should not invest only in domestic markets. There is a high probability that the financial products traded in foreign markets are less correlated with the products traded in the domestic markets.

The Balancing Act

Different themes, offered as schemes by fund houses, outperform during different periods.

Mid-caps tend to fall more than the large-caps during a downturn because of their high beta levels, a measure of volatility of a stock in comparison to that of the stock market as a whole. Also, since these stocks are less liquid than large-caps, they are inherently more volatile. Financial planners say mid-caps should not be part of your core portfolio at any point of time.

Beta is a measure of the volatility, or systematic risk, of a security in comparison to the market as a whole. A beta of 1, for instance, indicates that the security’s price will move with the market. A beta of less than 1 means that the security’s will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market and will move more than the market.

Spreading Risks

These funds provide wealth creation by investing across various themes and are underweight or overweight on sectors based on their outlook. Over a five to ten year period they would perform better than the Nifty.

Although it is difficult to lay down rules for allocation across investment themes, certain types of funds can help you achieve certain goals you may have in mind. Gold funds, for instance, could be used to plan for your child’s marriage. Large-cap or balanced equity funds are low-risk funds, hence, are suitable for conservative needs such as buying a house, your children’s education or retirement, he adds. Mid-caps or small caps should be used for near- term goals such as buying a vehicle or spending on a vacation because of their potential upside.

If you are a low-risk investor, increase the proportion of defensives in your portfolio such as FMCG, pharma or dividend yield stocks or funds; these will cushion your portfolio during market falls. But you should look at a two to three year time-frame for investing in such funds. The FMCG segment, for instance, continues to be plagued by margin pressures as input costs have been spiralling.

Further, thematic or sectorial funds can be used for taking advantage of market opportunities, but one must clearly identify a sector.

It reduced excise duties and interest rates, increased salaries through the Seventh Pay Commission and put money in the hands of the consumers. This benefitted the consumption-led sectors. Also the sector faced headwinds like limited off take, high capital and commodity costs and procedural delays.

However, with the economy back on track, the focus has once again shifted back to infrastructure as well as commodities such as metals and cement.

Need for attention

Investments in any particular sector as a theme in your portfolio should be done on one’s own only if you have the research expertise and conviction about the sector. You can look at investing 15-20% into sectorial funds, cautions.

The short point is – diversify sensibly and guard against overdoing it. Each fund should serve a purpose in your portfolio and any addition should ideally complement the portfolio appropriately.

Further, increase in the number of stocks beyond 30 will only dilute the performance of the best ideas. Some call this ‘di-worsification’ of the portfolio. And as you approach retirement don’t forget to rejig your portfolio to reduce the number of high-risk investments.

Legendary investor Warren Buffett, who does not recognise volatility as a risk and advocates a concentrated portfolio, qualifies that his approach is not suitable for everyone, definitely not for relatively inexperienced investors.

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