Sunday, May 14, 2006

Diversification!! how much?

“Don’t put all your eggs in one basket”

Almost every one of us would have heard this famous dictum in the world of investment.

If one goes by the efficient market theory – a proven hypothesis, not that the hypothesis is proven to be true; but it is proven to be a hypothesis for ever – stock price of a company reflects current value of all the future earning expected from its operation from today till judgment day. (It is found on various occasions that market prices a security in anyway but efficient). In the short term, stock market could be driven by expectation and emotions of mass psychology. But in the long run it should – and would – reflect the true business strength and earning potential of the company.

You might say “hey stop. Where are we heading? What does this got to do with diversification & famous egg and basket story?” We do certainly not get out of track yet J

Well. As discussed above, the stock price is subject to fluctuation based on the performance of a company and its business. If some one chooses to put all his money in a business, then his destiny is likely to be determined by the prospects of that organization irrespective of weather he lies it or not. Having entered at a wrong price at a wrong time in a wrong business could be fatal. Companies like Bioncon and Jet airways have a bad year in the bourses albeit unprecedented rise in the benchmark index of Mumbai stock exchange. This happened albeit their market leader position in their respective industries. This is what happens when you put all your eggs in one basket. You drop the basket, eggs are gone. These are technically called unsystematic risks peculiar to a particular organization whereas systematic risk is for the entire country, it’s economy and stock market.

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. It strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. 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.

Even carefully selected stocks can plunge at times (like Pricol) irrespective of good business prospects. This is where diversification comes in handy. Having a couple of losers in a bag of 10 stocks is not a bad portfolio. You have sufficiently diversified. Sometimes inevitable negative effects of some losers are offset by the propelling positive effects of many winners.

But….there is nothing worse in the world like diversifying for the sake of it. I myself have done the mistake of not putting more than a fixed amount in a particular stock. Buying stocks worth same rupee value in each counter was my modus operandi. As of today my portfolio consists of 39 stocks and 4 mutual funds. This is excessive diversification for an individual investor of my size and risk profile. A little retrospect leads to an interesting figure. I have bought/sold/held 96 different companies in my portfolio in the past 2 years. Despite this high diversification, about 73 % of my total gain has resulted from top 10 stocks. All of them were sure winners; at least I believed so at the time of purchase. Nevertheless heavy allocation was not made to these stocks as I had a mental block of a rupee value beyond which I did not want to pump into one. The top 10 securities are below.

Zuari Industries
Era constructions
Alstom projects
Industrial Investment Trust
Tata steel
Century textiles

Avoiding excessive diversification – that I know for sure was done for the sake of diversifying – actually dragged down the performance of my entire portfolio. It is only my hard earned experience and an insight derived from voracious reading leading to the conclusion that ‘diversification is an excuse we want to generously grant ourselves for the lack of knowledge & depth in decision making abilities’. Some people buy some stocks and lot of mutual funds simply to comply the comfort of diversification. Ultimately mutual funds that he holds might end of holding same securities he holds himself. He is not diversified as he perceives (or even deceives) himself. As we discussed in the definition, diversifying is an act of avoiding business (unsystematic) risk and not the systematic risk that can crash the entire stock market. Holding 100 different securities does not guard you from systematic risk. Evens like war, political change, foreign policies can attribute to them. Similarly when the portfolio size grows, you try to simulate the market, thus leaving the chance of getting above the market returns (should I call beating the market?) limited. Diversification intended for neutralizing the bad effects of losers with the winners might ultimately dilute the portfolio where the performance of winners might get dragged down by losers and average performers.

I probably have not spent a enough time in the capital market to comment on ‘suit for all’ recipe in terms of diversification. From my personal experience and the amount of learning from reading great men’s view in this field, an ideal portfolio could not be more than 25 to 30. Widening your horizon leaves you at a position where you probably don’t know what to track and what not to track. Focus on your strengths and dive with full energy when you see some thing of your liking.

I do not fail to mention about Warren Buffett in my writings. As per his own statements, if you leave top 10 decisions he took, his results were nothing but ordinary. Warren’s phenomenal show was not a result of widening diversification; but a result of focus and concentration!!

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