Does diversification necessarily work in your favour

Whenever you sit down with your financial planner or your investment advisor, one of the first topics that come up for discussion is the need to diversify your risk. What do we understand by diversification? In investment parlance it implies spreading your investment along different asset classes and asset sub-classes so that the overall risk of your portfolio is reduced. So, diversification is all about reducing your concentration risk. In fact, mutual funds are based on the premise that by holding a larger body of stocks the fund is able to better diversify the risk of the investor.

So, how exactly do you diversify your risk?

Reduction of risk happens through diversification in a variety of ways. The most basic form of diversification is to opt for investing through equity mutual funds rather than direct equities. When you directly buy equities, you hold a few stocks and therefore your concentration risk is too high. By holding a diversified portfolio of assets, mutual funds diversify your risk. The second kind of risk is asset class risk. If your portfolio is entirely focused only on equities, then your vulnerability to macro factors will be just too high. This can be resolved by adding debt to your portfolio. This will bring stability and regular income to your asset mix. Lastly, there is the instance of global diversification. Large fund managers like Templeton and Morgan Stanley have been investing across emerging markets like India and China for a long time. The idea is to reduce their risk of being solely exposed to developed countries. Each of these methods entails a different form of risk management!

The counter-argument and the Buffett Approach..

The counter-argument to the diversification theory is that by diversifying you reduce the risk as well as the return potential. Critics of diversification also argue that some of the world’s greatest investors like Warren Buffet and Carl Icahn have never believed in diversification and have made all their billions by concentrating their focus on just a handful of stocks. While that is technically correct; it is not everybody’s cup of tea to take that kind of concentration of risk. When you want to grow your wealth at an above-market rate for a long period of time, then diversification is the answer.
However, there are 5 golden rules for diversification to be successful..

Rule 1: Check out the correlation before you diversify..

The whole economic logic of diversification is that you combine assets that have low levels of correlation with each other. For example, if you are holding NBFC stocks and you try to diversify by adding real estate stocks, then the exercise is bound to fail as both these sectors have a high degree vulnerability to movements in interest rates. For example, oil producers benefit from higher crude prices and paint companies benefit from lower crude prices. Therefore, combining stocks of companies from these two sectors can provide diversification. Diversification must lead to reduction of risk and not substitution of risk.
 
Rule 2: Beyond a point, the incremental benefits of diversification start to diminish.
 
While there are no hard and fast rules, it is believed that for a standard portfolio diversifying across 12-14 stocks is enough to serve the purpose. If you try to diversify across all the Nifty 50 companies then the performance of your portfolio will almost mirror that of an index fund. That is surely not what you are looking at from equities. In the quest for diversification, one needs to ensure that you do not over-diversify. In fact, marquee investors have given a name for this and call it “Diworseification”.  So the crux of the story is to focus on a handful of stocks that genuinely provide you the correlation benefits.

Rule 3: Avoid going down the quality curve when you diversify..

This is a big risk irrespective of whether you are diversifying through equity or through debt. For example, if you diversify your equity portfolio by adding too many mid-caps and small-caps then short term out performance can be misleading. Many of these small caps may have vulnerable business models and they may be endangering your entire diversification effort. Similarly, when you are diversifying into debt, ensure that you do not go below AAA rated or at best AA rated debt. As we have seen in the case of Amtek Auto and Videocon, sudden downgrades can leave a huge hole in your portfolio.

Rule 4: Diversification will not help you when you are hit by a financial hurricane..

Remember, that diversification assumes broadly normal market conditions. When you are in market extremes like the technology meltdown of 2000 or the sub-prime crisis of 2008, then diversification is unlikely to give you any great advantages. These are Black Swan events and are likely to deplete asset classes across the board. Just because your diversification failed in the midst of a Black Swan event it does not make a strong argument against diversification.

Rule 5: Finally, diversification has a context..

Always look at your diversification effort in the context of your own financial goals. When you require liquidity over the next 6 months don’t try to diversify your debt portfolio risk by adding lower rated debt. That can impact your liquidity management. Similarly, if you are planning for your retirement, your focus should be on diversified funds. Trying to reduce the risk by adding sector funds will defeat the entire context of your plan. In all your decisions, your financial goals must have the upper hand.
While there may be exceptions, in a vast majority of the cases, diversification does make sense. It not just de-risks your portfolio but also protects your returns in volatile times!