Diversification is just a means to create a portfolio which is expected to provide good returns as well as reduce risk. However, diversification does not guarantee successful achievement of investment objectives

Diversification is a much talked about subject in finance. Right from our first lesson in diversification which says, “Do not put all your eggs in one basket” to Harry Markowitz research on efficient portfolio, literature on finance is full with detailed analysis of diversification and its benefits. It is common to find experts say that if an investor wants to reduce risk, he must diversify his portfolio. So what is this diversification that is supposed to provide immunity to portfolios from risk?

In simple words, diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. So the common suggestion is that one should invest in equity, fixed income and other asset classes to overcome challenges posed by the erratic behavior of financial markets.

While the apparent objective of diversification is to reduce risk and potentially enhance returns, there is an opposite school of thought that does not buy the logic and need for diversification.  One of the greatest investors of our time and wealth creator Warren Buffet believes, “Diversification is a protection against ignorance. It makes very little sense to those who know what they are doing”. While the number of those who know what they are doing may be less, the statement commands a great amount of merit. Another great investor Jim Rogers says, “The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket”. 

History is replete with examples which show that people have created wealth without diversifying and also without exposing themselves to risks. However, it may not be possible for all investors to create wealth without diversification. After all, a common investor is neither Warren Buffet nor Jim Rogers. An investor will always have fear of unknown. So what should he do? Should he diversify his portfolio or depend upon known investments without bothering about diversification. While it is obvious that investors get preached often on the need for diversification, let us look at the some of the reasons because of which diversification may not work for common investor:

Asset allocation is required for diversification but mere asset allocation does not ensure diversification: Investors often confuse diversification with asset allocation. The general belief is that by adding more asset classes in your portfolio or by adding more variants of same asset class, the portfolio risk will automatically get reduced as portfolio is diversified. Very often there is a discussion on how many schemes of mutual funds an investor should invest so that the investments in equity get well diversified. In other words, how does the benefit of diversification of benefit apply and to what extent it is effective? There are some generic answers available for these questions. In response to mutual fund investments, most experts suggest five to seven schemes without carrying out a genuine study on diversification benefits and also knowing well that some risks cannot be diversified.

In other cases, the generic answer given is—either have more stocks in your portfolio to make it diversified, or add fixed income in equity to diversify the portfolio.  Let us look at the carnage that we saw in 2008 in the Indian stock market as well stock markets around the world. There was not even a single sector which was left untouched from the events that unfolded post crisis in the US. A very well diversified equity portfolio got hit as badly as not so a diversified portfolio. So in a bad or non-performing market, diversification does not essentially work. Even in cases, where stocks, fixed income and other asset classes such as gold is there in a portfolio, there may be limited benefit of diversification as it will depend upon asset allocation and may ultimately defeat the objective of highest possible return with lowest risk. This kind of portfolio can only give nominal return to the investor which may be less than risk-free investment in a standalone basis.

Investors have limited understanding and information on co-relation factor and diversification ratio of asset classes: Co-relation is a critical factor in understanding risk. It gives an idea about how different asset classes are related to each other in terms of returns. The co-relation between some of the asset classes are known but not all asset classes. It has been often observed that investment in gold provides safety net during crisis. This means that when performance of other asset classes is under strain, gold performs in an opposite way. However, such kind of information is not available for all asset classes and hence an investor may end up investing in different asset classes which have limited co-relation benefits. Two positively co-related asset classes may act against the investor’s interest during the period of non performance.
 

Apart from co-relation factor, many investors do not understand the concept of diversification ratio on which the modern portfolio theory is based. This ratio is the portfolio’s weighted average asset volatility to its actual volatility. The result of this calculation measures the essence of diversification. In fact, it may be practically possible for an investor to apply this ratio in investments.

Systematic risk cannot be eliminated with diversification: Investments are prone to systematic and unsystematic risks. While it is possible to reduce unsystematic risk by diversifying investments, systematic risk is something that all investors have to accept. In a country like India, the recent experience of political idiosyncrasy is a clear-cut example of how investors are left exposed to high risk in equity investment in spite of other things remaining constant. In fact while global markets are almost booming, investors in stock markets have lost heavily. Other systematic risks associated with government policies, interest rates and global economic outlook is not possible to predict and hence diversification won’t work.

While diversification has so many limitations, why it is that diversification is often recommended as a strategy as part of investment. Diversification is just a means to create a portfolio which is expected to provide good returns as well as reduce risk. However, diversification does not guarantee successful achievement of investment objectives. Recent experience of crisis world over shows that even after diversifying a portfolio, an investor may not be safe. In many countries during the recent global economic crisis, all financial assets have moved in one direction showing limited benefit of diversification. Diversification needs support of the market to perform and does not essentially provide protection against the vagaries of the market.

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(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)