| How much Diversification is Good |
Traditional finance teaches us never to put all our eggs in one basket. In a nutshell this is referred to as diversification of portfolio. The idea being that if you spread your investments across more investment avenues, your risk is spread thin. But, let us first understand how diversification reduces risk.
In finance parlance, risk is of two types. Systematic and unsystematic risk. Systematic risk refers to that risk which is at a Macroeconomic level and affects all the scrips in the market. Examples of systematic risk are changes in inflation, interest rates, economic growth, foreign exchange risk, political risk etc.. Unsystematic risk on the other hand refers to that risk which is at a specific company or sector level. Examples of such risk are labor trouble in a company, changes in the duty structure of a particular industry, ineffective management etc.
The difference between these two kinds of risk becomes extremely relevant because while unsystematic risk can be diversified away, systematic risk cannot be diversified. Let us understand this subtle difference. If an investor holds shares in cement manufacturer ACC, and if the prices of cement starts falling, then the ACC scrip will go into a downtrend. But an investor can diversify this risk by holding shares of Cement and Construction. This is because while ACC will suffer from a fall in cement prices, a construction company will benefit from a fall in cement prices and that will reflect in prices.
What this means to an investor is that, if he wants to diversify his risk, he needs to hold securities in his portfolio which are negatively correlated. Which means when one stock gives a positive return other stock should move in a negative direction. The question then arises, how many stocks does one need to hold in the portfolio to make it diversified.
A few quick pointers :
Diversification makes sense only upto a level of 15 stocks. Beyond that the marginal contribution of each stock to risk diversification is minimal.
Diversification makes sense if stocks within a portfolio are mutually negatively correlated or at least less than perfectly positively correlated.
Investors need to be careful when selecting too many stocks with similar characteristics, because that would lead to risk substitution rather than risk reduction.
Diversification needs to be done across asset classes, sectors and styles. Firstly, an investor needs to hold different classes of assets like stocks, bonds, real estate and gold in his portfolio so that the cyclicality of his portfolio returns is minimized. Secondly, stocks should be spread across unrelated sectors or preferably negatively correlated sectors. Thirdly, investment should be across styles like aggressive management, defensive management, small cap stocks, large cap stocks etc.
What diversification enables an investor to do is to reduce his risk by controlling cyclicality of returns. So, go ahead and get the diversification advantage. But remember the points mentioned above.
T S Harihar
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