Diversification is the strategy of spreading one’s money across multiple investment options. In its simplest form, it involves dividing one’s money across as many different kinds of investments as possible; in its more sophisticated form, it involves assessing which investment categories to have one’s money into, and to what extent (also referred to, as ‘asset allocation’). Diversification makes one’s portfolio less dependent on the performance of a single investment or category of investments. It can also minimize the impact of unpleasant surprises that may affect any single investment or category of investments.
In my opinion, the single most important reason to invest in mutual funds is the speed and convenience with which an individual can actually build a diversified mix of investments. In this post, I would like to share my thoughts on some questions related to diversification that I am often asked.
“If I invest in a safe place such as a PPF or a bank deposit, do I still need to diversify my investments?”
For a number of people, the term, ‘risk,’ implies the potential loss of capital, and ‘safe’ investments are those that implicitly or explicitly guarantee against that. Fact is, risks come in a variety of forms, and all investments, including those that we might consider as ‘safe,’ carry some kind of risk. For instance, most ‘safe’ investments carry the risk of not beating inflation. By diversifying across investment categories, we can use the strengths of one investment category to offset the risks of another. To illustrate, equity investments can offset the risk of not beating inflation, that debt instruments carry. Debt instruments, in turn, provide a cushion against the risk of price fluctuations, that equity investments carry.
Additionally, there are some risks that could affect any investment or investment category but may not necessarily impact all investments or investment categories at the same time. For instance, there is the risk of an unexpected and inconvenient delay in getting back one’s money. (Just in case you find this difficult to relate to, you might like to visit online consumer grievance sites and check out the complaints related to withdrawal of investments, including those made with government-owned institutions.) Diversification helps minimize the impact of such a risk.
“Is there any point to diversifying across multiple equity funds if they all hold shares of the same or similar companies in their portfolios?”
True, our gains from a fund are linked to the gains from the underlying investments. More specifically, other than in index funds, our gains are linked to the gains that the fund manager derives from the underlying investments. Two funds may have the shares of the same companies in their portfolios, yet the specific reasons for the respective fund managers to hold these could be very different. These fund managers may have different price targets to accumulate, and different price targets to sell.
Thus, there is merit in diversifying across funds with similar portfolios if the fund managers are different, and they employ different strategies.
“Wouldn’t an equal diversification across multiple equity funds result in average returns?”
While an equal diversification will result in average returns relative to other equity funds, my experience, and the evidence that I have examined, lead me to believe that it is likely to result in above-average returns relative to other investors. Let me explain.
As suggested in an earlier post, I believe it is difficult, if not impossible, to know which funds will do well, relative to others. Yet, as I also hinted, our brains are wired in such a way that most of us cannot resist the impulse to predict winners, so to say, and invest in them. Once we do so, a number of us try to improve the odds by frequently switching funds. This adds costs and usually reduces returns. Last, but not the least, when prices fall, a number of us panic and get out and stay out, and miss the inevitable rise in prices, as and when that happens. All of this results in returns that, more often than not, are less than what could have been achieved by simple diversification. My analysis also suggests that if one were to do a basic, qualitative screening of the funds to diversify across, the results would be far more in favor of diversification.
