Diversification – the simplest tool to manage investment risk

Picture this. Your family is embarking on a vacation to a faraway place where cash is the only accepted mode of transaction. You are hence forced to carry a large amount of cash with you on the trip. Now, would you put all the cash in one bag with one person of your family or spread the cash among many family members? It is obvious that the first option entails huge risk. Theft or misplacement of the bag would mean that all your money is gone and your vacation is in the doldrums. You may have to end your trip abruptly and scramble to arrange your return journey. On the other hand, if the total money was split into many small sums and handed over to each family member, the risk of loss of money is minimized. It is highly unlikely that everyone would lose the money in their custody. This process of minimizing risk by splitting the money and putting it in different places is referred to as diversification in investment parlance.

It is pertinent to note that this approach does not eliminate the risk totally but only tries to minimize the consequences of that risk. While there are events beyond your control, taking steps to ensure that the resultant impact on you is minimized, is well in your control.  Diversification is the first step in protecting your investment from market forces and your own mistakes. Read on to know more…

What is diversification?

“Diversification in the investment context is the process of spreading your money among different types of assets and strategies with a view to minimizing risk”.

While physical dispossession is not such a real threat with financial assets, there are risks emanating from movements and events in the economy and securities market which can impact your investment portfolio. For example, the stock market may slide sharply and cause erosion of your capital or the company whose debenture that you hold may go bankrupt thus putting your capital at risk. With real estate and gold, it could be quality issues or loss of market value or even dispossession. Every investment asset carries some risk or the other but fortunately they are all exposed to different types of risk and to varying levels. So, by combining them prudently in your portfolio through the process of diversification, you can minimize the overall risk of your portfolio.

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Different ways to diversify your investments

Diversification of your investments can be at different means and levels such as:

Across asset classes: By including debt, equity, gold and property in your portfolio, you are reasonably safeguarded from the possible poor fortune of any of them at a given point in time. You also get to participate in the good fortunes of these assets by maintaining a presence in them at all times.

Within an asset class: Even within an asset class, you would do well to spread your investment in more than one product or avenue. For example, you would agree that putting all your money in the deposit of only one bank is quite risky and you require more banks to minimize that risk.

Across geographies: Different regions or countries experience different levels of economic prosperity at any given time. So having a presence in more than one country / region not only protects you from a possibly prolonged and severe economic downturn in India but also enables you to participate in other countries’ good fortunes. You can invest abroad directly if you have the knowledge and experience or you may invest through mutual funds.

Across investment strategies: There are investment products that follow a growth strategy and there are those that follow a value or dividend yield strategy while investing in stocks. Similarly, some debt funds follow an income accrual strategy while others look to gain from capital appreciation. You would do well to have a mix of few strategies in your portfolio as each will have its periods of boom and gloom.

Pitfalls of over-diversifying

Just as lack of diversification is harmful to your portfolio, the opposite scenario of over-diversification too is harmful because:

  • It involves too much monitoring: You would have too many investments to track and evaluate which would be cumbersome and involve higher transaction costs. This may lead to fatigue and eventual neglect of your portfolio.
  • It lowers returns: Even if one or few constituents of your portfolio perform exceedingly well, you would not experience any meaningful gains as they would form a negligible portion of your portfolio.

Diversification through mutual fund investing

Mutual funds by nature are well diversified investment vehicles as they spread your money among different assets and securities; so even a modest amount invested experiences adequate diversification. In addition, you may also spread your money among different schemes and fund houses so that you gain from their varied investment styles, philosophies and approach. But you need to take care that:

  • You do not invest in many funds with the same objective / style / strategy because it does not lower your portfolio risk in any meaningful manner.
  • There is not too much of overlap of underlying securities among the funds in your portfolio for the same reason as above.

5 signs that your portfolio is not properly diversified

  1. High concentration risk: One or two investments make up a major portion of your total investment portfolio. For example, let’s take a look at the portfolio below:
AssetPresent market value% of your portfolio
Bank depositsRs.10 lakh8%
GoldRs.20 lakh16%
PropertyRs.90 lakh72%
EquityRs.5 lakh4%
TotalRs.125 lakh100%

Here, property occupies nearly three-quarters of the portfolio and combined with gold constitutes ~90% which indicates high risk, since any slide in their price could burn a large hole in your portfolio.

  • Asset allocation gets skewed: Asset allocation is the next stage of diversification wherein you determine how much to allocate to each asset, keeping in mind your financial goals, risk profile and investment horizon. This ensures that your portfolio is well positioned to achieve your investment objectives and that your preferred risk-return balance is maintained. You need to have a well defined asset allocation structure to achieve a risk-adjusted return that helps you achieve your financial goals. Consider this case:
 Recommended asset allocation to achieve desired investment objectivesPresent asset allocation

The above shows that the portfolio is skewed towards property and it has to be rebalanced by directing further investment towards other assets. If your portfolio tilts heavily towards one or two assets more than the desired level, you may not be adequately diversified.

  • Skewed market capitalization: In equity investing, companies are differentiated according to the market value of their total number of shares. Based on the total market value, they could be classified as large cap, mid cap or small cap with their investment risk generally increasing in the same order. Financial prudence demands that you have a specified exposure to these market caps to achieve good investment returns with optimal risk. If your portfolio misses out one or two of these market cap segments, your portfolio may not be adequately diversified.
  • Sectoral concentration: Businesses operate in one or more sectors, which are nothing but industries grouped on similarity. For example, businesses that produce and deal in cars, trucks, two-wheelers, etc. are grouped and identified as the automotive sector. There are many such sectors and it is important that you have an exposure to a few sectors for the sake of diversification. If your portfolio is heavily overweight on one or two sectors, your portfolio may not be adequately diversified.
  • Obsession with a particular stock: Investors sometimes get emotionally or experientially attached to certain stocks. Reasons could be ancestral holdings, first equity investment, etc. Such investors tend to be over-exposed to that company’s fortunes and hence lack adequate diversification. Investing through mutual funds would steer you clear of this risk as mutual funds hold a number of stocks in any portfolio.

To conclude: As with everything else in life, there are events and situations that are beyond your control while investing. Though this lack of control is real, the possibility of safeguarding your hard earned money from a severe impact is also equally real. Diversification is the simplest tool to manage investment risk. It is also the most effective remedy to risk reduction that an investor has access to.

Team FinanceInsights

October 22

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