“Don’t put all your eggs in one basket”
This is one of the most well known and simplest ways to explain diversification. The idea behind it is simple.
If the basket falls, not all your eggs will be destroyed in one go since they are spread out in different baskets.
Diversification is a very important strategy in investment management and portfolio creation. More so, because we are dealing with money, our hard earned money, which we want to use to achieve our financial goals.
In this lesson, let’s understand diversification from a different perspective.
It is a great method but some people really take it too far.
The story of my friend Yash and his investments
A few days ago, I was talking to my friend Yash and we happened to touch upon the topic of his investments. Yash is an interesting name. In Sanskrit, Yash means fame, repute (also reputation).
You look at his portfolio and you will find in it every investment that you can think of.
There are Mutual Funds (debt, equity, hybrid, over 50 schemes), Direct Stocks (30 of them), Unit Linked Insurance Plans (who doesn’t have them), Endowment and Money Back policies (another 5 in all), Post Office Deposits, Bank Fixed Deposits, National Savings Schemes, Public Provident Fund, Corporate Deposits, Infrastructure Bonds, Land and Gold (physical as well as through ETFs).
And he mentions proudly that he is planning to invest in an International fund too.
I looked at him aghast and asked “So, why are you doing this? What is behind this huge array of investments you have?”
Yash took his eyes off from the exciting football match on TV and replied, “You see my friend, I don’t know what investment is going to perform in the near future. Hence, I have put in money in all these. Some will perform, some will not but overall I will manage a decent return and be safe. And you only told me a few years ago, not put all eggs in one basket.” He grinned.
I shook my head while managing a feeble smile.
I asked him further, “What is total value of these investments?”
Yash started thinking and said, “I am not sure of the current value but as an approximation I think it should be around Rs. 25 lakhs.”
Now, it was time for me to fall off my chair. I managed to say, “You are spreading your money too thin, my friend”.
Yash had got the concept of diversification right but he had stretched himself too far in its implementation.
I took it upon myself to inform Yash to get his diversification right. I had a detailed conversation with him and that is where the 7 step approach to a diversified portfolio emerged.
For your benefit too, here are they.
The 7 step approach to build a Diversified Portfolio
#1 Know where are you going
What do you want to achieve with your money? Do you want an early retirement, fund your children’s education, buy a house or a car, save for charity or just travel around the world. You have to be as clear as possible about these goals. Then establish a value for each goal, the time period in which the money is required and how important it is (priority).
‘To know where you are going’ could be the single biggest determinant of financial success. It directs our actions firmly towards the goal and enables us to make appropriate decisions even in unclear situations or conflicting information.
When I asked Yash, if he had done a goal setting exercise for himself, his face drew a blank. Clearly, GOAL is a word he associated only with football, his favourite sport, which he continued to watch on TV.
#2 Understand the stakes – how much risk can you take
“Yash, you got to pay attention here”, I almost scolded him. He sheepishly turned the volume down and turned towards me. I continued and asked him, “How much risk can you take?”
He thought for a while and said, “I am basically a risk taker. I think I can take a lot of risk.” I explained.
Risk is the uncertainty that is attached to outcomes. When you are not so sure about the outcome of a certain action, you call it risky?
In the domain of investments, risk means the ability to see erosion of your investment value, specially those that have been invested in market linked securities like stocks (or mutual funds). However, the risk is more so present in short term, say in 5 years. If you are willing to be invested in market linked securities for over 5 years, the chances of losing money are far less.
Sometimes, you may have an attitude to take on risk, but your capacity may not allow you. You may have more immediate needs of funds or you have a loan to retire and hence the capacity is low. The vice versa is equally true.
You may be financially well off but you may not want to risk your money at any cost. Either ways, you have to assess where do you stand in terms of your risk taking capacity.
Yash nodded and said, “I feel I would be a moderate risk taker.”
#3 Spread it wide into asset classes
An asset class is a category of investment. While there can be several options within an asset class they tend to have similar risk and return characteristics. For example, you can invest in equity either directly or through mutual funds.
The most commonly referred to asset classes are Equity, Debt, Real Estate and Gold. Other asset classes would be commodities like oil and alternative investments like international funds.
Now, as per your goals, time horizon and the risk taking capacity, distribute your savings in these asset classes. Why so?
“Yash, as you mentioned earlier that you cannot have a perfect idea of what asset class or investment will perform.” To reduce this risk, the best you can do is to invest in different asset classes. If one is not doing well, the other’s performance could compensate for it.
Typically, when equity markets are down, Gold tends to go up. In periods of high inflation, equity markets may not do well, but debt would outperform.
Investing across asset classes cancels out the risk of one another to some extent, and thus reduces the overall risk. This is also called the diversification benefit.
“I agree,” Yash said as he raised his both hands up in the air.
#4 Dig deeper – choose asset class sub-categories
Inside every asset class, there are further categories that you can choose from. Take for example, Gold. You can buy physical gold or you can invest in Gold Schemes of Banks or you can also buy a Gold Fund that invests in gold mining companies and then of course you can buy an Exchange traded fund or a Gold ETF.
Real estate typically has residential property, commercial property and land.
In equity, you can look at various sectors and the specific stocks within those sectors. A sector call could be to invest in defensive sectors (those that do well even in an economic downturn) like consumer goods, banking, etc. and then going one step further, you would want to commit your money to the largest public sector bank or the consumer goods company that has started showing a high growth in its sales.
Similarly, in debt, you could choose between corporate bonds, government bonds, Gilts, short term treasury bills, etc. Each comes with its own unique characteristics.
Yash concluded intelligently, “So, what you are saying is that I can use the sub categories to further diversify risks and create a better risk-adjusted return.”
#5 Pump some real weight
Yash got excited and told that he had invested in this multi-bagger stock that got him 300% return. I was like wow. I couldn’t hold back my enthusiasm and remarked, “You must have become a millionaire by now”.
Yash’s face dropped as he replied, “No. I had invested only Rs. 10,000 in the stock, so it became Rs. 30,000.”
“Oops!”, I said. And that led me to this conclusion.
If you want your investments to make a significant contribution to your portfolio, then you have to get them to have some real place first. Something that is 1% of the portfolio can only make a 2% impact, even if it grows by 200%. If the same investment is 10% of the portfolio, it can grow the portfolio by 20%. This will be true of the asset class such as equity, the sub category, such as the sector and the stock within that sector.
Don’t over-diversify like my friend Yash did. For example, if you are taking exposure to equity through mutual funds, about 3 to 5 mutual funds should provide you all the diversification benefit that you are looking for.
My recommendation is to get exposure to no more than 7 to 10 investment instruments, overall across asset classes. This will ensure that they have adequate weight to make any serious impact on the investment portfolio performance. Don’t spread your money too thin.
#6 Put strategy over tactics
“Yash, if you look again at your portfolio composition, it appears that you bought stocks or mutual funds that were expected to do well and invested small amounts of money in several insurance policies and various post office or bank deposits.”
“Yes, that’s right”, Yash agreed.
This is more of a tactical approach to diversification, that is, trying to benefit in the short term through specific information with an expectation of quick gains. Tactical is good but it should always come after the strategic. If you rely on a fully tactical investment style, you put yourself at great risk of not meeting your financial goals adequately.
The strategic approach to diversification is what we have discussed so far – defining the goals, deciding the asset classes and allocation between them based on time horizon and risk taking capacity.
You could also divide your portfolio into the strategic and the tactical, say in a ratio of 80:20. The strategic takes care of your long term goals, while the tactical is used to benefit from market movements or to invest in very high risk instruments / sectors.
As an example, you can invest in diversified equity funds or in large sized companies as a strategic approach towards the long term goals. While for short term tactical gains, you could invest in Gilts or mutual funds that invest in Gilts. We witnessed a falling interest rate scenario and they could stand to benefit hugely in value. (Remember: There is an inverse relationship between interest rates and value of debt instruments.)
“Are you suggesting me that I add one more investment?”, Yash sounded confused.
I had to clarify quickly, “No, in fact what I am saying is that you first put your plan and your strategy in place.”
I heard a deep “Hmmm” from him.
#7 Strike the re-balancing act
When I asked Yash, if he had been rebalancing his investments, pat came his reply, “I have only seen Ronaldo balancing the ball on his head. The rebalancing you are talking about has gone over my head.”
I should have expected that. I switched off the TV making Yash visibly unhappy. I ventured into an explanation.
Whatever diversification you create initially, it has to be monitored over time and adjustments made to reflect your current priorities, goals, time horizon and risk taking capacity. Like a rope walker or someone like Ronaldo, you have to keep striking the balance regularly so as to derive the best risk-adjusted returns from your diversified investments.
The typical reasons you need to re-look and re-balance your investments are:
- You could be reaching certain goals in the near term. You need to move your assets from risky ones to more certain ones. A need for funding your daughter’s college education in 1 year would mean that you should withdraw the money and park it in a safe fixed deposit with a bank.
- The market movements could change the value of your market linked investments such as equity, gold, real estate, etc. This would result in a shift from the original allocation. For example, equity markets have risen 100% in the last one year and hence they now stand at 34% of your portfolio instead of the 30% that you had allocated to them. You would need to adjust your numbers so that they go back to about 30% of the overall portfolio.
Yash listened very carefully. He did not react for some time and suddenly we stood up, walked into his room. I was afraid whether this was the reaction to my switching off the TV.
After about 10 minutes, he emerged carrying about a dozen files with sheets of papers falling through them. He put them on the table and said, “I want to set my portfolio right. Let’s put the 7 laws of investment diversification into practice starting right now”.
We both looked at each other and smiled.
Quick recap of the 7 steps for investment diversification
- Know where you are going – define your goals
- Understand how much risk can you take
- Spread your investments into asset classes
- Choose sub-asset classes
- Provide adequate weightage to your investments
- Don’t rely on random tactics – have a strategy in place
- Rebalance periodically
Does your financial life sound like Yash? If not, ensure you don’t get into his situation.
This note is a part of the free course – Investing 101. Want to subscribe to the full course on email?