There is a very popular maxim, 'Do not put all your eggs in one basket'. This is the fundamental principle on which the premise for diversification of equity portfolio rests. However, another maxim has come up to counter the above argument, 'Put all your eggs in one basket and watch it carefully'. So what is the right investment strategy? Lets find out!
We shall first see the advantages (if any) of NOT diversifying the portfolio. The supporters of an undiversified portfolio often argue that it is virtually impossible for a small time investor to track a number of stocks at the same time. They believe that if one is confident about the performance of a company or a sector, why not invest the maximum in that stock/sector and reap very high returns? Yet a diversified style of investing has been recognized as the ideal one. Here's why...
Diversification of equity portfolio involves dividing the investible funds across various sectors. The primary objective here is to get 'optimum' (not maximum) returns with minimal risk. Return is the reward you get for bearing risk. Risk is of two types viz., unsystematic risk and systematic risk. Unsystematic risk is the risk that is company specific like a strike or fire in a particular company. Diversifying the portfolio can mitigate such a risk. Systematic risk on the other hand is the risk that is associated with all the companies and sectors and can hence not be diversified. Thus diversification helps one bring down the risk involved in stock market investment.
Now to counter argue some of the issues raised by those against a diversified portfolio. Although it is true that a retail investor cannot track a number of companies at the same time, he can always seek advise from independent equity research houses that give unbiased view on stocks. Further, when invested in a particular stock or sector and that gains subsequently, it would translate into very high returns. However, if the stock crashes, a major portion of the investment will get wiped out. This is exactly what happened in the 2000 tech boom.
During the boom, people invested in software stocks with little fundamental knowledge of the company's business. The investment decision was based on sentiments and greed to make maximum money. Although initially such investors might have reaped much higher returns as compared to a diversified portfolio, they would have also lost the maximum when the IT bubble went bust. Thus, a diversified equity portfolio seems the right way of investing. This is even more so during a bullrun, wherein, there is tremendous price volatility which could give many a sleepless nights to an investor had he invested in a single stock.
However, investors need to note that diversification does not mean investing in 'any' and 'many' stocks. With 'any' stock we mean that the fundamentals of the company should not be compromised with. Further, 'many' stocks indicate that an investor should limit the number of stocks in his portfolio rather than having everything that looks to good to him. The reason for this is obvious i.e. difficulty in keeping a track of all the stocks in the portfolio.
Also, investors need to properly plan their diversification strategy. While planning the same, time horizon (i.e., period for which the investment is being made) and the risk appetite (capacity to bear risk which is dependant on the age, financial position, future needs, etc of the investor) should be considered. Once the risk bearing capacity is decided, the investor must select stocks that would yield him optimum returns. This apart, while picking stocks, an investor needs to also ensure that the stocks selected are not highly correlated. Thus, diversification should not only be within the sector but also across sectors.
Thus, although investing in a particular stock and reaping high returns sounds as a lucrative and exciting proposition, it is very difficult to put it in practice and succeed time and again. The very fact that even the best of minds can miscalculate, there is little probability that a retail investor would be able to select a stock, which could be a multi-bagger. Moreover, the volatility in that stock is sure to keep him worried during his holding period, as the upside as well as the downside risk in such an investment strategy is very high. Investors, hence, need to keep a diversified portfolio, which will keep the risk exposure under check and yield optimum returns.