Imagine a farmer growing only one crop a year, say wheat. This implies that his agricultural income is dependant on only one crop. Now suppose if something wheat-related went wrong like inconducive weather, or pest nuisance or unfavourable wheat market. The farmer is in real trouble. Overreliance on just one crop exposed him to a lot of risk. Had he diversified his crop-base to some millets, some rice plantations, etc, his income would have been protected to an extent.
In the world of investments, portfolio diversification is similar to farming. It helps to effectively protect the downside in investments. Let us understand how one can effectively diversify his/her portfolio and reduce the inherent risks involved in investing:
At the Asset Level: It is imperative for investors to diversify across different asset classes. This helps to spread out the risk as different asset classes behave differently under different economic conditions. Assets are broadly classified into Equity, Debt, Gold and Real Estate. For example, when the equity markets were down 30 per cent last year during the March 2020 quarter, debt investments earned stable returns and gold mutual funds returned 11-12 per cent, in fact outperformed debt and equity as an asset class. Diversification across asset classes can thus help to spread out risk and protect the portfolio.
At the Company Level: Investors sometimes develop a bias for a certain stock/company. Maybe it is the business that they like or could be because of expectation of good earnings result or some other positive development. Investors may lap up shares on a regular basis of such companies and may not realise that the portfolio is concentrated in a few shares. Investors should hence avoid concentration risk and set a maximum limit for every stock in their portfolio.
At the industry level – Many a times investors adopt a top-down approach and select stocks based on the industry the companies operate in. Here again, too much exposure to any one particular sector can be very risky. For instance, too many construction/capital goods stocks in a portfolio will not shield it from downside when these cyclical sectors do not perform well in an economic slowdown. Even in mutual funds, investors park money in thematic funds which exclusively invest in stocks of a particular industry, e.g., IT, banking, pharma, etc. Be it investing in stocks/mutual funds, investors need to ensure that their investments are adequately diversified across sectors.
At the fund level – There are 36 categories of mutual funds in India as defined by SEBI and each have their own unique purpose and risk element. Many a times, it is observed investors have multiple large cap funds, tax-saving funds, etc in their portfolio. Such duplication will only generate sub-optimal returns. In fact, too much concentration in relatively riskier categories like mid cap, small cap, etc., can pose grave risk to the total portfolio. Investors thus need to ensure that proper diversification across fund categories is achieved as per their risk appetite.
At the AMC level: The Franklin Templeton episode where the fund house shut down 6 of its debt schemes together provide investors a grave reminder and a valuable lesson. Although the fund house has been returning the money in tranches, investors faced liquidity issues, especially the ones who had substantial money locked in schemes of just one fund house. It is thus imperative for an investor to diversify his investments across schemes of 3-4 good fund houses.
At the Geography level: It is important to invest in the international markets for the right reasons. And, global diversification should be the primary reason as this will ensure that the portfolio does not depend upon the fortunes of any single market. It reduces the risk of underperformance of a particular market/geography. Additionally, one gets to diversify across sectors and companies which are a part of emerging trends in technology, research and innovation and lack presence in India.
The general approach to investments is usually a bid to save tax or when a lumpsum amount has accumulated or to act on some hot stock tip. Such haphazard investing many a times lead to overdiversification with investors typically ending up with 20-25 mutual funds in their portfolios. Such a cluttered portfolio does not yield the desired results. Diversification does not mean having X number of stocks and Y number of mutual funds in the portfolio. Investments needs to be diversified in a structured manner so as to balance risk and reward and in sync with financial goals. One can consult a professional investment advisor who can guide on the right track in this regard.