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Diversify or be defenceless

Diversification may be a defensive strategy, but it is a good one to employ

Diversify or be defenceless

When we talk about mutual fund investments and the advantages an investor derives from them, we list out a lot of advantages. However, the one that stands out above the rest is diversification. The theory of diversification is very simple. All investments don't do well simultaneously. The normal state is for some investments to do well and for others to not do as well or to even do badly at a given time. If you happen to be over-invested in something that is doing badly at a given time and not at another, then you are going to have a problem.

The promise of diversification is that it saves you from the poor performance of a narrow set of investments. If a particular company or sector is suffering, having only a limited exposure to it helps. Other than sector-wise diversification, it is useful to also diversify with respect to company size, as there may be times when only smaller or larger companies are doing well or poorly. Diversification can also be geographical, and involves investing in foreign stocks, generally through international funds that are offered by Indian fund companies.

Theory and practice
That's the theory. In practice, mutual fund investors deal with funds and not sectors or individual companies. Taking a naive view of what diversification is, many approach diversification by simply buying many funds. This may seem logical: that an investor with just one fund is not diversified; that one with two funds is a little more diversified; and one with 20 funds is extremely diversified. Fund advisors for their part tend to feed this illusion because it is good business.

The result is that it is actually not unusual to find portfolios with 20 or 30 funds. And the investor is perfectly satisfied in their portfolio being so 'well-diversified'! However, the fact is that since funds are themselves invested in a large number of stocks or bonds or both, adding funds to your portfolio after a certain point does not materially add to the degree of safety of your investments. It even compromises their manageability. To sum it up, diversification is not a goal in itself. It has the downside of adding to your workload. You should do the minimum required and no more. So what is this minimum level of diversification? And how do you ensure that the diversification is real and not illusory?

Real diversification
Whether a portfolio is well-diversified or not is a matter of degree. Perfect delinking of the various components of your investments may not be possible. All parts of the economy are after all related, and a broad, severe crisis of the kind the world saw in 2008 will affect everything. In theory, though, the holy grail of diversification is to spread your money across negatively-correlated types of investments. Negative correlation means that when one goes up, the other comes down. Unfortunately, this would mean that some part of your portfolio will always perform badly.

Realistically, diversification is a defensive strategy that is only partially successful only part of the time. But don't dismiss it, as it is much better than being defenceless.

This story first appeared in January 2014.