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Investing: Diversification or concentration? - Views on News from Equitymaster
 
 
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  • Aug 3, 2006

    Investing: Diversification or concentration?

    The stock markets continue to witness significant levels of volatility with each passing day. Mixed views are being heard on the street, with some believing that the BSE-Sensex will go all the way down to 7,000! Others are saying that it will trade 'range-bound' (although a 'range' may even be between 7,000 and 15,000!), while yet another camp believes that come Diwali, or some other festive season, it will break its 'resistance levels' and cross 15,000!

    Well, we would like to refrain here from giving any view on index levels, as we do not attempt to predict the same. Our focus is more on stock-specific recommendations that have the potential to outperform the benchmark index over the long-term. However, this is not the focus of this write-up. We elaborate here, the pros and cons of 'diversification', one of the ways to minimise portfolio risks.

    The case for diversification...
    The basic logic for diversifying one's portfolio is, "Do not put all your eggs in one basket." This theory has a solid foundation behind it. For example, if an investor decides to invest only in steel stocks, he or she is putting himself/herself at risk at times when the steel cycle starts to turn down. Now, keeping track of such trends is no easy task, and even the most seasoned of industry veterans have got it wrong occasionally. Thus, there is a case to invest in stocks across sectors, so that in case of a downturn in any one sector, the performance of stocks from other sectors would make up for the losses suffered in that sector.

    Let us understand the basic rationale for diversification. It is to reduce risk. Now, there are 2 types of risks - systemic and unsystemic. Systemic risk is that which impacts all sectors and companies, and, thus, cannot be diversified. Examples of such risks include events such as 9/11, an attack on an important crude pipeline, changes in political leadership, geopolitical risks (North Korea nuclear programme, the Israel-Lebanon conflict) and government policies. On the other hand, unsystemic risk is a risk that is specific to a particular company, such as a strike by factory workers for Hero Honda, or a fire at Bombay High for ONGC.

    Therefore, diversification of a stock portfolio serves the purpose of reducing the unsystemic risk of that portfolio. As a result, a major purpose of diversification is 'optimising' returns (as opposed to maximizing returns, which might involve a higher level of risk). One must understand that returns can never be de-linked from risk - they are never mutually exclusive and always co-exist.

    ...and against!
    On the other hand, by not diversifying the stock portfolio, rather concentrating it towards a few stocks, an investor can (still) get higher returns. Of course, as mentioned above, such a strategy would more likely than not involve a higher degree of risk. For example, an investor decides to tilt his or her stock portfolio towards software stocks. Now, while the software sector undoubtedly has strong growth prospects, taking a call on which stock to invest in to outperform the benchmark index is a none-too-easy task for a retail investor, who might not have the time to study the stocks, their business models, management teams and future prospects. Therefore, in order to execute such a focused investment strategy, an investor must have the ability to spot trends in his or her sector of interest, and time it accordingly.

    Conclusion
    We believe that it is not easy to outperform a diversified portfolio on a consistent basis. While in the short-to-medium term, this strategy may work, over a longer period of time, it is unlikely to be successful.

    Of course, the risk profile of the individual also plays a part in deciding the asset allocation. In one's younger years, an investor can afford to take greater risks. Thus, it is more likely that when one is in one's 20s and early 30s, the portfolio will be less diversified, both in terms of sectoral allocation as well as market cap-wise (skewed towards mid-caps, more likely). We believe that over a longer period of time, a diversified stock portfolio can outperform a concentrated one. Of course, if an investor has the wherewithal to outperform a diversified fund by concentrated investing, he or she is welcome to do so. Take your pick!

     

     

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