A number of investment principles might appear to have failed, but they certainly shouldn't be abandoned
19-Mar-2009 •Dhirendra Kumar
One of the worst aspects of the crashing investment values has been that the most time-tested principles of investment appear to have failed. For years, concepts like diversification and gradual investing have been the cornerstones of financial planning. You won't find financial planners admit it in so many words, but these principles have been the most prominent victim of the stock crash that we've been living through.
I have always believed that whenever stock prices crash, having investments in a wide variety of sectors and industries would be a protection against the worst that the markets can do to you. The logic was supposed to be impeccable. Economic troubles usually limit their impact to some sectors. Even if stocks of companies in all sectors fall, the affect is generally less severe in many of them. This was certainly true in the last crash. Everything did badly during the 2001 crash, but the kind of carnage seen in technology stocks was absent from more mature industries. The worst of that crash was limited to technology and the related dotcom froth.
This time around, doesn't seem to have worked at all. You could have been broadly diversified across every major sector; it would hardly have impacted your losses. Some may have done worse than others. Others may have done better or worse at different times. Even in the current mini-recovery that stocks are enjoying, some sectors are better off than others. But being diversified hasn't saved investors from the crash. When the entire economy is in doldrums, diversification isn't any help.
Beyond sector-based diversification, there's geographical diversification, but that didn't work either. Admittedly, only a few Indian investors invest abroad-there are only a handful of mutual funds through which this can be done. In any case, even if you had been fully diversified across every major economy in the world, your losses would still have been just as bad. This failure of geographical diversification is the flip side of globalisation. If the entire world's economy gets more integrated and interlinked, then the effect will be seen on the upside as well as the downside. The good times were global, and so are the bad times. This may sound like a rather severe conclusion, but it may be the world's economy is so interconnected now that geographical diversification has been rendered useless. Being invested across the globe sounds like a cool idea, but any severe crisis is likely to be global and your investments will then be losers everywhere.
Besides diversification, there are other longstanding principles that have suffered. Investing gradually over a long-time, as in a mutual fund's Systematic Investment Plan (SIP) has still left investors with deep losses. Currently, even investors who have been regular with their SIPs for three to four years have losses. The 'long-term' that protects from losses seems to have been pushed back from three or five years to perhaps seven years or more. This in a country where the equity investing culture considers three months to be long-term!
What does this mean? Should we abandon these basic principles of investing? Not quite. What this does mean is that these principles get stretched in the kind of extreme crisis that the world is facing now. And they haven't really failed. We all know people who weren't diversified-the ones who were invested in a handful of hot stocks.
To understand the value of diversification, compare their losses to those of any well-diversified mutual fund.