Diversification : Don't Put all your Eggs in One Basket !
"Don't put all eggs in one basket" is very well-known quote in the investing community. Objective of the statement is to distribute the risk so that failure of any single investment does not have material impact on overall return of the investor. Technical term for distributing risk is called "Diversification".
Diversification can be done across asset-class like equity, debt, commodity, real estate etc. If you invest in assets that do not move in the same direction at same time and same pace then one can get benefits of diversification. Eg. In 2008 when the stock markets crashed big time, equity portfolios delivered high percentage of negative returns but at the same time debt(bonds) delivered positive returns which mitigated negative return to a certain extent for an investor who held equity and debt both in his portfolio at the same time. In this post we will deal majorly with diversification in respect to equity.
Diversification from Equity Perspective :
Why is there a need for Diversification ? Investment in shares is done after performing the necessary analysis. Analysis may be either technical analysis or fundamental analysis. How much ever detailed analysis is done it is never possible to determine and understand each and every variable out there in the universe impacting share prices. There is always a possibility of analysis turning out to be wrong due to change in known variables, or unknown variables may have adverse impact on the share prices and thus create risk of loss for investor. To reduce the impact of such risk, diversification is done.
Investment in shares provide opportunity for higher growth in long term. However the return from investment in shares is very volatile in nature due to drastic fluctuations in the share prices.
Important Points in respect of Diversification :
Diversification can be done across asset-class like equity, debt, commodity, real estate etc. If you invest in assets that do not move in the same direction at same time and same pace then one can get benefits of diversification. Eg. In 2008 when the stock markets crashed big time, equity portfolios delivered high percentage of negative returns but at the same time debt(bonds) delivered positive returns which mitigated negative return to a certain extent for an investor who held equity and debt both in his portfolio at the same time. In this post we will deal majorly with diversification in respect to equity.
Diversification from Equity Perspective :
Why is there a need for Diversification ? Investment in shares is done after performing the necessary analysis. Analysis may be either technical analysis or fundamental analysis. How much ever detailed analysis is done it is never possible to determine and understand each and every variable out there in the universe impacting share prices. There is always a possibility of analysis turning out to be wrong due to change in known variables, or unknown variables may have adverse impact on the share prices and thus create risk of loss for investor. To reduce the impact of such risk, diversification is done.
Investment in shares provide opportunity for higher growth in long term. However the return from investment in shares is very volatile in nature due to drastic fluctuations in the share prices.
Important Points in respect of Diversification :
- What type of shares to chose in portfolio of stocks for diversification will depend upon the risk appetite of the investor (Aggressive/Moderate/Conservative). However, stocks from same sector can be avoided in single portfolio from diversification perspective
- As per our understanding not more than 10% of equity portfolio must be invested in a single stock. Maximum of 15 stocks may be held in any equity portfolio. Holding very few stocks will increase the risk whereas holding stocks in excess of 15 is likely to dilute the returns along with the risk
- Warren buffet once said that "Wide(Over) diversification is only required when investors do not understand what they are doing". Wide (Over)- Diversification is time consuming, inefficient and also leads to increase in transaction costs of investor, reducing the returns
- Total Risk in Investment = Systematic Risk + Unsystematic Risk
- Systematic risk is the risk which can impact adversely the entire stock market or financial system as a whole. Eg. Political Instability, Natural Disasters, Change in Tax laws, Economic crashes, Recession Etc. It is difficult to manage or mitigate systematic risk due to it's inherent nature
- Unsystematic Risk is the risk which can impact adversely shares of a specific company or a specific sector. Eg. Change in regulations impacting one industry, Financial Fraud in a company, strike by employees of an airline company etc. Unsystematic risk can be mitigated to an extent with the help of diversification
- Diversification is very important tool available to all the investors which helps them survive in the financial markets and maintain a balanced growth in the long term
