Diversification – How to do it and how not to do it

Lot of people don’t understand the need for diversification. If they did, they wouldn’t go and buy houses or land spending tens of lakhs of Rupees, being in debt for 25-30 years paying EMI. I am not against getting your own home to live in, but there are people who think real estate is the best investment and keep buying more houses, believing they can get rental income from it.

These are the people who have more than 80% of their net worth in real estate. If it is not real estate, it will be gold or fixed deposits. I don’t have a problem in investing in different asset classes, I even suggest that you should spread your money in different investments. That is what most of the financial planners also say.

How you split the investment should be based on your long-term goals and not how many apartments or gold jewellery your neighbour or relative has. If you are a young investor, you should have majority of your investments in equity and a very small amount in debt/gold. If you absolutely need to buy a house for living, remember to also invest a sizeable amount into equity, so that you begin saving enough for your retirement or your kid’s education.

Diversification in Stocks

The concept of diversification can be applied to individual stocks or sectors too. If you invest directly in equities and you keep buying just one specific share, you are putting all your eggs in that particular company. If that company faces a problem, no one can save you and all your capital can be erased within a few days.

But you may say that you invest only in large cap stocks and these are the companies that can never go down, right? Wrong. Have you heard of Satyam? Hindustan Motors? and literally hundreds of such big companies that tanked either in a few days or over the years. Anything can happen to any company at any time. In the case of Satyam, it was the problem with the Chairman and in case of Hindustan Motors they failed to innovate and it is almost wiped out.

Diversification in Sectors

So, now you may say, “Ok. Instead of buying just one company, let me buy all the companies in a particular sector.” That is also equally risky. Whenever bad luck comes, there is a high possibility it comes for the entire sector. Public sector companies, real estate, infrastructure, sugar are some of the examples that are down for many years now. If you invested in a single sector – say real estate, you would have gotten zero returns or even negative returns overall.

When a particular sector like real estate gives you negative returns, there will be other sectors, like Pharma or IT till 2013 which outperformed. Collectively all these sectors would save you from any adverse effects of a particular policy decision (or lack of) in a sector – like sugar or mining or power. That is why you should always spread your investments across sectors.

Diversification in Size

This is also important. You can play safe and invest in only large cap stocks. But large cap stocks can only grow unto a certain limit. If you need returns more than that, you would have to invest in mid-cap or small-cap stocks. While they are more risky and can be more volatile than large-cap stocks, in case of a bull market, they can give you much higher returns on your portfolio

Mutual Funds to the rescue

Now for a retail investor to analyse the thousands of stocks and the various sectors’ movements and market cap can be impossible. Also to track this every month and rebalance his portfolio is simple unthinkable. Now this is where mutual funds are going to help you. Investing in mutual funds gives you all the benefits of diversification and none of the headaches associated with analysing it.

Since Mutual Funds automatically invest in numerous stocks (typically 30-50 stocks) split across sectors and are also categorised based on the Market Cap of the companies it invests in – it is the easiest solution one could think of. All you need to do is pick the right mutual funds and you can just keep investing in SIP and just track the performance of the fund instead of individual stocks. Performance of individual stocks is something you leave the fund manager to worry about.

Diversification in Mutual Funds

Diversification is good right? So should you go invest in 10 or 15 mutual funds and enjoy the safety? There are people who do this too. I have seen people who are investing in 10-15 mutual funds – they feel happy that their investments are protected. This is the most dumb rookie mistake and if you think even a teeny-tiny bit what happens you would understand.

When you invest in a large-cap fund (A), what does the fund manager do?
He chooses the best 30-50 stocks from the universe of about 200 large-cap stocks and puts your money into them.

Now lets goto large-cap fund (B), what does the fund manager do?
He chooses the best 30-50 stocks from the universe of about 200 large-cap stocks and puts your money into them.

Now lets goto large-cap fund (C), what does the …… (you get the idea?)

If you are going to invest in N mutual funds which has the same objective, you are not really diversifying. You are in fact investing in the same stocks over and over again, because there is going to be a lot of overlap. You are going to have even more headache because you now have to track the performance of 15 funds.

So, what should you do?

Diversification is needed in mutual funds, but it does no good if done blindly. You should diversify only across market caps and not across the fund houses or fund managers. All you would be needing is invest in

• one large-cap fund
• one mid-cap fund
• one small-cap fund

For 99.9% of the investors who want to invest in balanced equity funds, this combination should be more than enough. The percentage of the split would vary depending upon your risk tolerance and the market conditions. If you need to diversify across asset classes, there are funds for that too. which will solve most of your problems.

Remember, Mutual Funds are designed to make your life simpler. Once you begin to micro-manage stuff, all kinds of crazy stuff comes out. So investors need to first understand about diversification – why you need to do it and when you don’t need it, before going and picking numerous stocks or funds for their portfolio.