The concept of diversification is considered to be sacred in the field of finance. However, is it something you should do or rather ignore?
Almost all the finance books indicate that risk and return are directly proportional. If that is true, you don’t need a portfolio manager or a financial advisor. Think about it, if you have to assume more risk and earn extra that you can do yourself, why pay someone to do it for you.
The basic principle of investing should be that you never lose your capital. Permanent loss of capital is the REAL risk.
Modern Portfolio Theory (MPT) was pioneered by Harry Markowitz during 1950s. This theory gained momentum in 1970s and the concept of diversification became the most important aspect of portfolio management.
Modern Portfolio Theory shows that an investor can construct a portfolio of multiple assets that will maximize returns for a given level of risk.
Diversification is a way to reduce your investment risk and give you exposure to several different asset classes.
Let us understand when diversification is good and when it turns evil.
If you are an investor who does not have an understanding of how the market works, diversification is key to your strategy. You have to ensure that your portfolio is a mix of all possible asset classes. These would include equity, debt, real estate and gold.
The proportion of investment in each of these asset classes would wary from person to person. In case you are young and have a high tolerance for volatility, equity and real estate is suitable. Else you would invest less in these asset classes.
It is important to understand your needs and yourself before you decide on your investment portfolio strategy. Your sense of your behavior is the key to your financial success. Market doing well or not doing well should NOT indicate what kind of asset allocation you should have.
So, it’s simple, if you do not have experience investing, diversify. On a similar note, if you do have experience investing, you should diversify less.
Let’s say you work in an IT sector. You know what is going on in the sector. If you were to invest directly in stocks, you should ideally have more companies in IT space than any other industry. Your understanding of the IT industry will help you take contrarian positions in stocks.
Being contrarian is the only way to generate a supernormal return in investing. This is possible only when you have a deep understanding of sectors that you have studied or are involved closely. You have a general advantage over others being an insider to the industry.
Often investors enter a certain asset class when the asset class has become popular. This popularity based investing often is detrimental to the overall performance of the investment portfolio.
If you do not have investment experience, it is better to diversify. Invest in index funds, ensure that you diversify as much as possible. This does not mean you buy four large-cap funds, but rather, one large-cap, one mid-cap, one small-cap and maybe one micro-cap. The exact proportion will depend upon your specific investing behavior.
One the other hand, if you have investment experience, try to diversify less and take contrarian positions. Best time to invest is always when the industry or a company is going through a bad time.
Create two sets of the investment portfolio:
Core portfolio (Diversified portfolio): Your core investment portfolio should be made of conservative investment options. These investments should meet the core requirements of your life such as retirement, child's future, home etc.
Satellite portfolio (Concentrated portfolio): Once your core requirements are fulfilled, you can create a satellite portfolio. These investments are primarily for growth and should be made for a long time horizon. You can have those specific asset classes or industry where you have relevant experience and knowledge.
Diversification can add value but has a limitation of capping your returns. Less diversification can help generate super-normal return but only when odds favor you.
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