What is Diversification?
Ever heard of the cliché phrase ‘do not put all your eggs in one basket? The lesson here is that if you pool all your resources and effort into doing one thing and if it fails, there are no alternatives left. Let’s imagine you went back to 2017, when the iPhone just launched and the only ‘smart’ phone available in the market was Blackberry. I remember everyone had to have a Blackberry.
The 52-key keyboard made it easy to send text messages and email, and BBM revolutionized the way we communicate with one another. If you were to pool all your money at the time into this one stock, you would have lost 90% of your money invested in 10 years.
Diversification is a technique that reduces investment risks by allocating your investment among various financial instruments such as stocks, bonds and ETFs. It aims to maximize long-term returns by investing in different areas that would each react differently to the same event.
Types of Risks
Here is a list of the common types of risks when investing in stocks.
- Market Risk: This is also called as systematic risk and is based on the day-to-day price fluctuation in the market.
- Business Risk: This risk can be escalated if the business is not doing well. Reasons like the failure of management, poor quarter-by-quarter results, or your misjudgment in picking a company come under business risk.
- Liquidity Risk: Liquidity is the ability of the company to pay its debts without suffering catastrophic losses. Companies with high debts may find it hard to pay their bills. Many times, they might even cut the dividends or in the worst case, may go bankrupt.
- Taxability Risk: The government changes taxes all the time and hence taxes may increase or decrease in the industry where you invested. The change in taxation can affect the stock price.
- Interest Rate Risk: The open market or global market interest rates changes time to time. And this can positively or adversely affect the stocks depending on the direction in which the interest rate is moving. For example, when the interest rates are high, the cost of interest to a company with high debt might cause a decrease in their stock prices.
- Regulatory Risks: There are a number of regulations imposed in the different industry which must also be termed as the risk involved in stocks. For example, Cigarettes, telecommunication, beverages, pharmaceutical and few other industries are highly regulated.
- Inflationary Risk: With an increase in inflation, the price of raw material will increase, which can affect the production cost. Many companies involved in commodities like oil, soya bean are affected a lot by inflationary risk.
- Social and Political Risk: Many companies face problem due to social and political risks. For example, Tata Motors shifted its Tata-Nano plant from West-Bengal to Sanand- Gujarat because of political reason, which cost a lot of money to Tata.
- Credit Risk: The risk that the company who issued the bond won’t be able to pay the interest or repay the principal at maturity and may find it hard to buy/sell goods.
- Currency and exchange rate risk: Many companies who deals across nations or the companies involved in import/export may face a problem with increased dollar price. Therefore, the currency and exchange rate fluctuations might increase risk in these companies.
What makes a Diversified Portfolio?
Asset Allocation: Investment strategy that aims to balance risk and reward by distributing your investments into 4 main asset classes – equities (stocks), fixed-income (bonds), cash and equivalents and alternative investments such as real estate and cryptocurrency. Each asset class have different levels of risk and return, so each will behave differently over time.
To learn more about allocating between stocks and bonds: The Beginner’s Guide to Stocks and Bonds
Industry Allocation: The act or practice of including securities in different industries in one’s portfolio. This is done to reduce systemic risk.
Stock Allocations: Within each industry, this is the practice of investing in similar companies which reduces the risk inherent in any one investment. An example of this is if you wanted to make a bet in ride-sharing, you would invest in both Uber (NYSE: UBER) and Lift (NASDAQ: LYFT) to mitigate the risk of one losing market share to the other.
Disadvantages to Diversification
While there are many benefits to diversification, there may be some downsides as well. Here are the key disadvantages to diversification.
Complexity: A well balanced portfolio requires a lot of technical knowledge in order to accurately hedge stocks against each other. An example of this technical analysis is the modern portfolio theory where it proves that it’s possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk.
Cost: Because diversification requires you to buy and sell many different stocks, the cost associated with the transaction and brokerage charges can add up. If you’re looking to purchase stocks yourself and not seek help from mutual funds, it also requires a high capital investment in order to buy the amount of stocks needed to have a diversified portfolio.
Diversification for Beginners
There are 3 ways to quickly diversify your portfolio without the complexity.
Mutual Funds: Mutual funds are professionally managed investment portfolios that allow investors to pool their money together to invest in something. Inside a typical growth stock mutual fund are stocks from dozens, sometimes hundreds, of different companies—so when you put money in a mutual fund, you’re basically buying bits and pieces of all those companies.
Exchange Traded Funds (ETFS): Type of security that involves a collection of securities such as stocks that often tracks an underlying index. A market index is a hypothetical portfolio of investment holdings which represents a segment of the financial market.
An example of this could be the S&P 500 which consists of 500 large-cap U.S. stocks, which combine for about 80% of all U.S. market capitalization. The advantage is that exchange-traded fund is a marketable security, meaning it’s listed in the major exchanges with a ticker and price. This makes it very easy to be bought and sold.
Robo Advisors: Robo advisors are digital platforms that trade on your behalf using algorithms and little human supervision. A typical robo advisor walks you through your financial situation, plan and age when considering how much risk they should take on your behalf. The product works exactly the same as a mutual fund, but with the benefit of a lower management fee. To learn more about robo advisors: The Beginner’s Guide to Robo Advisors.