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Diversification is often misunderstood by amateur investors. An idiot’s guide
If you are investing in the market, one bit of advice you’re sure to hear is— ‘Don’t put all your eggs in one basket.’ Which is another way of saying that you should not risk putting all your money in any one asset class. Ideally, you should spread it across asset classes—equity, debt, real estate etc.—to reduce risk. So this is basically about getting the right asset allocation, depending on your goals and risk appetite. It seems simple, but investors often end up getting it wrong. There are many myths about the merits of diversification. Here are a few common ones:
More funds/ stocks equal better diversification:
People misunderstand diversification and invest in an unmanageably large number of mutual funds and stocks to ‘diversify’ their portfolios. But they forget that overdiversification can lead to dilution of returns. A fund or stock may not contribute enough to the portfolio return—even if it’s doing well—if it doesn’t have significant weightage in the mix.
You don’t need to diversify within an asset class:
Diversification happens at many levels. You not only need to diversify across asset classes but within an asset class too. For example, if you have invested in equity, you need to diversify your portfolio across sectors and stocks. Depending on your preferred riskreward profile, you may want to diversify even among stocks—and invest in a judicious mix of large, mid and smallcap companies as per your risk appetite. If you are investing in equities via mutual funds, you will need to diversify across schemes and across fund houses to avoid concentration risk. Investing across fund houses will automatically diversify your portfolio across fund man agers. So your portfolio will not be hit hard if one fund manager takes a wrong call.
Risk profile is not so important:
On the contrary, while diversifying your portfolio, you also need to consider your risk profile. Suppose you have invested in equity and debt in the ratio 80:20. If your goals are short term, you can’t risk having 80 per cent of your portfolio in equities. Also, to be properly diversified, you need to rebalance your portfolio regularly. The allocation to different asset classes will change according to their respective performances, which may again not be as per your risk appetite. So you will need to adjust your allocation to the various asset classes to remain diversified.
Diversification is a foolproof method of avoiding losses:
Diversification reduces the risk because if one asset class/ stock/ fund underperforms, the gains from the others compensate and the overall portfolio returns are not so badly hit. If you have both equity and debt in your portfolio, then in case of a stock market crash the debt portion will cushion the portfolio (your losses will be less). At the same time, if you have both debt and equity in the portfolio, your returns will most likely be lower than in an allequity portfolio.