“Do not put all your eggs in one basket” is an idiom which we picked up at school while familiarizing ourselves with the subtleties of the English language. Some amongst us have learnt it the hard way though, when they have inadvertently dropped a basket full of eggs. The result eventually is a mess, monetarily, physically and visually.
So what is the remedy? Obviously it is simply by dividing the eggs and keeping them in separate baskets. In the financial world a lot of investors follow a path to the contrary. They fail to heed this time-tested idiom. Their fate is the same as that of broken eggs.
How to diversify your investments?
Even at the cost of repetition, it is necessary to reiterate that by not diversifying a portfolio the investor runs the risk of being financially wiped out. It is always useful to remember that if the base of a physical structure, be it a building or a monument, is wide, it is literally on a better ground. Thus, by diversifying or spreading out the investment corpus, the investor is on a better footing.
The process of portfolio diversification for investors is neither easy nor is it a one time exercise. A discipline in approach needs to be instilled in the minds of the investor while trading in the stock market. Allocating investments among various financial instruments is the key to diversification. While no market pundit will ever claim that diversification can hedge against market losses, it is definite that it helps to mitigate damage when things are bad.
Let us consider an example where a high net worth individual has assets worth rupees 5 crore. Out of this, the value of his immovable asset in the form of an apartment in a prime location in Mumbai is worth 4.5 crore rupees. If suddenly by some untoward act of God, his apartment is damaged beyond redemption, then his entire investment value comes to nought.
Another example is about this gentleman who was fond of purchasing stocks of one particular IT company. These stocks had given him lavish returns during previous years and so he never thought beyond it. One day the market went Topsy-Turvey and all his money went for a toss.
These are examples which we commonly come across and they adequately highlight the ill-effects of non-diversification. Here are six very useful options for readers and investors which can be followed for portfolio diversification:
I. Across Asset Class: Not all investors are well conversant with the nuances of stock markets and it is always safe to investment in an array of avenues like stocks (equity, mutual funds), debt instruments, commodities like gold and/or silver etc., real estate and retain some liquid cash. II. Within Asset Class: A particular asset class will be made up of similar type of option across various companies or instruments. The equity investments can be spread across different sectors. FDs can be made with different banks. Instead of investing in one equity fund, you may divide that into 3 different equity funds. III. Across Geographical boundaries: Investors can always choose to spread their investments globally. This will add a dimension to the investment corpus as it will provide the added advantage of benefits accruing out of currency fluctuations. Properties can be purchased in different countries across the world. This will give the investor a fair chance of minimizing losses in the event that a country is rocked by natural calamities or political upheavals. This will insulate you from the currency fluctuations.
IV. Across Capitalization: When you invest in stock market, you can spread your investments across different market capitalization like small cap, mid cap and large cap. You can do this diversification when you invest directly as well as when investing through mutual funds. Large caps are less volatile when compared to mid and small caps. Mid and small cap has got more return potential when compared to the large cap.
V. Across Time: The investor can spread out his investments systematically based on the time index. Some short term (say 3 years), a few medium term ( 3 to 5 years) and other long term (above 5 years) investments will provide a good balance and flair to the portfolio. A little planning will help the investor in deciding his priorities in life and investment accordingly. From purchase of a house, to studies of children and eventually their marriage, everything can be achieved by taking time-bound investment decisions.
VI. Across Style: By style it is meant that the investor can choose between regular income generating and capital appreciation. You can also spread your equity investments across different investment styles like value investing and growth investing. You can diversify your debt portfolio with the investment styles like accrual based fund management and duration based fund management.
It is relevant to state that over-diversification can prove to be counterproductive, after all ‘too much of anything is bad’ and going by Warren Buffet’s dictum “Wide diversification is only required when investors do not understand what they are doing”, it is better to not overdo things. A sensible approach, one in which the investor will remain standing, a balanced portfolio which is not too wide, is considered ideal.
The author is Ramalingam K, an MBA (Finance) and Certified Financial Planner. He is the Director and Chief Financial Planner of Holistic Investment Planners (www.holisticinvestment.in) a firm that offers Financial Planning and Wealth Management. He can be reached at email@example.com
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