Categories: Financial Glossary

Diversifying Your Portfolio – Everything You Need to Know About Diversification

Let us understand diversification and see why Indians are craving for portfolio diversification and help you diversify your portfolio even if you know very little about the market.

What is Diversification?

Holding large number of stocks in many industries in many sectors of the market builds a protection against the horrific loss that can occur if all the money is invested in one industry and one sector and that industry or sector is badly effected.

So in a diversified portfolio, some stocks will go down and some stocks will go up and fingers crossed it is assumed that the one that goes down will be less than the one that goes up. In short Diversification is used for minimizing risk of investing in market.

Why Indians are overwhelmed with Diversification?

The answer is when we (including me) jump into market, we aren’t sure of what we are doing and why and so when we hear the quote from a friend or colleague

Don’t put all your eggs in one basket.

Which means that one should not invest all the money in one company and this becomes a thumb rule for our investing journey.

I have seen people believing the above saying so well that they tend to invest in some other company once they have more money to invest and not prefer to be investing in the same company that has been doing well in their portfolio.

Diversify to the extent that you can watch all your investments. Don’t make it too difficult to watch all your eggs in all the different baskets. Don’t be overwhelmed with the concept of diversification. If you don’t do it right, it can add more issues than it solves.

How any Indian Retail Investor who knows very little about the market Diversify?

If you are an Indian retail investor and know very little about the market, you can invest in all the funds in a given index or you can invest in selected few sectors in the index which you think can do well in next few years and avoid certain sectors as a whole. That can help you make your portfolio diversified.

So for example if you take up all the 30 stocks in Sensex, and avoid few stocks that you think is not a sector for next few years, the performance of your portfolio will be at par with Sensex which is what is an index funds does (as we will see).

Mutual funds allocate more money in sectors they are more bullish on and bet little on other sectors. As an example when market is bullish, they will invest more in technology or banking sector but when market turns bearish, they move towards Pharma sector. Index fund tries to mirror the index with the assumption that index is made up of different stocks in different sectors to provide them good amount of diversification.

Diversification provides good risk management but it also means you may end up getting mediocre results.

If you don’t want to be doing such investments to the index stock yourself, investing in an index fund can also provide you exactly similar results but then you pay the expense ratio to the fund house for doing it for you.

Should Indian Retail Investor Diversify or go for Focus Investing?

Money is neither created nor destroyed but it just change hands in market. I call it as zero sum game, which means someone has to loose money for others to gain it. 90% of Indian retail investor loose money in market and it is needed so the 10% of the people can make money from the market. If you are not sure of how market works and know nothing about market, it is better to be investing with diversity.

Pick any index like Sensex, Top 50, Top 100 and invest at the right time in those index stocks, it would mean you are better than those traders who know nothing about the market and are among the losers. If you are one among the 90% of the people, you can make a move towards those 10% mark in the long run.

Focus investing means you choose few stocks that are more likely to produce better than index returns and invest into those stocks only. If you can invest in fairly right time, you are more likely to be making great money from market.

In both the focus investing and diversifying investment, you have to make sure you invest at the right time and so go with the one that best suits your knowledge about market.

Why mutual fund house prefer diversified investment over focus investing?

Fund house has dedicated fund managers with hundreds of crores of rupees to manage and still they prefer to go with diversified investment to focus investing just to avoid being answerable. Fund managers are paid a salary and so they are answerable to their boss, SEBI and ultimately to the customers for performance of their funds. Once you select a benchmark and invest based on a benchmark, you are more likely to perform at par with the market and so they are not in the firing line when thing are not working as expected. Apart from that can answer to the issue – benchmark is not performing.

Lets look at performance of HDFC Top 200 (BSE 200 index benchmark) and Reliance Growth Fund (BSE 100 index benchmark) for last 3 years.

As expected the funds are doing what index has been doing.

Final Thoughts

If you invest in different companies just for the sake of diversification, move to focus investment and try to understand what the business of the company is.

According to me Diversification of investment should not be all about investing in different companies and different businesses but it is more about investing over a different or diversified time period. You can diversify your investment into one company over a period of 3 years as well.
Couple of quotes on diversification from all time great investors

Warren Buffet:

If you are know-something investor and able to understand business economics, and can locate five to ten sensibly priced companies that posses important long term competitive advantages, diversification makes no sense for you.

Phil Fisher: