In older times, it was advised not to put all your eggs in one basket. The modern lazier times have coined a single word for it : diversification. It points to spreading the investments over a variety of assets to reduce the overall portfolio investment risk.
Diversification typically helps in reducing the exposure to a particular asset class or risk. It is a known fact that all asset classes e.g. equity, fixed rate deposits, gold, crude, real estate etc. go through their respective cycles. As the image below (Source – bemoneyaware) showcases, each calendar year during 2011-2015 had a different asset class outperforming other assets.
While the category of aggressive investors commit themselves for longer term to the investments in stocks, conservative investors would formulate their strategy around debt instruments e.g. fixed deposits, corporate debentures etc. Each asset class has its own advantages and risks. Investment in stocks is relatively liquid but considered risky, debt investments give lesser returns but more likely than not, preserve and ensure the safety of the amount originally invested.
Hence, an individual must create a good balance between the risk and returns. No asset class, including stocks, have consistently delivered positive returns always. The right kind of solution to these situations is to create a diversified mix of assets which has bit of stocks, bit of debt investments, bit of real estate and bit of gold. Further, even within a particular asset class, one must be reasonably diversified to avoid concentration risk into a particular kind of investment. However, one disadvantage associated with diversification strategy is that while it limits downside in the portfolio, it tends to limit upside potential too.
So, without going much into the technical details, I will like to put forth practical examples of various concentration risks :
- Company Specific Risk – Whether it is in stocks, deposits or real estate, one must not really invest in a single company. Company specific problems do have the capability of completely derailing one’s portfolio e.g. if someone had invested in Kingfisher Airlines stock when it was running at its full capacity, company specific problems could have eroded whole of the capital. Had one invested in a basket of stocks including little in Kingfisher Airlines, the loss of capital in one stock would have got compensated from the returns in the rest of the portfolio.
- Industry-Specific Risk – To reduce the risk of investing only in Kingfisher Airlines, Aditya also tried little diversification and invested into Jet Airways and Spicejet. Now, even though he is relatively better in terms of risks his portfolio faces from investment in Kingfisher Airlines, still the risk of concentration of investments in aviation sector needs to be focused upon. A hike in Aviation fuel prices can hamper the portfolio returns.
- Sector Specific Risk – Well, continuing with the diversification strategy, Aditya looks for investment in a couple of more stocks and ends up investing in Cox & Kings and ThomasCook. So, even when he reduced his concentration into aviation sector, he still continued with concentration in travel industry. Hence, any changes in saving and income patterns can affect the industry relying heavily on discretionary spends,
- Company Size – Companies with different sizes tend to react and perform differently, due to different capacities to absorb external shocks and also to capitalise over the opportunities. That’s why it is always recommended to invest over a mix of large cap, mid cap and small cap companies. For ex. Yes Bank, once a small bank offers much higher growth prospects than State Bank of India, owing to its already huge base.
While the discussion above has been concentrated over diversification across investment in stocks, similar rules can be applied in debt investments too and investment be made in instruments varying in different maturities, credit rating etc.
The Means to Diversify
One can easily choose in invest in mutual funds which offer investments ranging widely in all kinds of companies, sector specific companies, different asset classes etc. One just has to choose a target mix and then select the appropriate fund. Mutual funds are managed by professional fund managers and hence, provide an assurance of the better management of the funds invested.
Further, an ideal mix of equity-debt combination is a percentage equal to the age going into debt instruments and the balance going into equity investments. Also, to have a pinch of the yellow metal in the portfolio, investment may be made in gold ideally not exceeding 10% of the total portfolio.
Happy Investing! Happy Wealth Creation!
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