When you start your investment journey, you are often told to invest in a basket of securities so that you can minimise the risk that stems from investing too heavily in one stock or sector. In other words, you are urged to diversify.
And it is, undoubtedly, a universally-accepted way to curb the risk of capital loss. However, the problem begins when you overdo this diversification. Although there is no doubt that diversification helps in minimising the risk but it comes at the price of foregone gains.
Let us understand this with the help of an example:
You want to invest ₹100 in stock ‘A’ but found it risky, so you decide to diversify. Now, you invest ₹50 in ‘A’ and the remaining 50 in safer instruments – say gold, debt, FD etc. With this, you have prevented the loss of half of your capital which could happen if ‘A’ went bust.
Let us say, ‘A’ goes bust causing the wipe-out of half of the investment. ₹100 invested becomes ₹50 then you have managed to prevent some of the losses by locking away your ₹50. And despite the massive crash that led to 50 percent wipe-out, your total capital remains ₹25 + 50 = ₹75 which could have been ₹50 if you did not opt for diversification.
|Before Crash (Rs)
|After crash (Rs)
But what if the crash didn’t take place. Conversely, the stock surged.
In case of a stock surge, say, by 50 percent, your gains will be capped up to 50 percent since the remaining 50 percent are locked in the ‘safe’ instruments.
Now, let us imagine to cut down the proportion of diversification. If you invest 70-75 percent of your capital in A or similar stocks falling under the risky category, your gains would be higher.
So, the bottom line is this: diversification is good when done in the right proportion. And even the experts also agree.
“Each sector has its own cycle. Performance of theme or sector basically depends on demand and supply, economic condition and nation's growth, and government policies. Diversification helps in refraining from relying on a particular stock or sector if you want to invest for the long term,” says Preeti Zende, Founder of Apna Dhan Financial Services.
Sridharan Sundaram, Founder of Wealth Ladder Direct, says “Too much of diversification leads to overlapping in the portfolio. One must realise that the entire investment universe is made of only 500 securities. All 42 mutual funds, and investment schemes are investing in these 500 stocks. There are two levels of diversification. One is among the asset class i.e., equity, debt, gold and property. This should be done appropriately. The second is diversifying within mutual fund space. Here, too much of dilution will lead to overlapping,” says
“Having said this, one should avoid the concentration risk which is when you are invested into too few stocks,” he adds.
Ms Zende, too, agrees to this.
“The over-diversified portfolio dilutes the returns. The concentrated portfolio is good but if it's under diversified then it will be a disaster,” she says.
Risks one undertakes
When you decide to opt for less diversification, and bear a higher risk, you ought to bear in mind that the exceptionally high returns usually happen in case of small and mid-cap stocks.
“High risk can lead to high returns when you invest in the small and mid-caps instead of large caps,” says Sridharan.
So, what is the ‘right’ balance one can strike to maintain diversification without losing out on earning opportunity.
Abhishek Dev, Co-Founder and CEO Epsilon Money Mart says that the objective for an allocation is to balance risk against reward — i.e., to get reasonable returns without taking unreasonable risks. Hence both over or under diversification are not advisable.
He further adds that the general principle behind asset allocation is that you should diversify by putting your money into various types of investments so that if one type of investment loses value, some other investment will make gains to help you make the difference.