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The Importance of Portfolio Diversification

The Importance of Portfolio Diversification
Reading Time: 6 minutes

The first advice offered by most experienced equity investors/advisors, especially for new investors, is to always maintain a well-diversified portfolio. From academic research/literature to mutual funds and renowned investors like Warren Buffett – portfolio diversification is perhaps the most common advice that’s given to investors across the world. Such is its importance. But before going into benefits of maintaining a well-diversified portfolio, let’s understand the risks associated with equity investing and the true meaning of portfolio diversification.

There are two types of risks associated with any equity/stock investment

The first kind is the broader market risk. This is not specific to any company in particular, and instead impacts the entire stock market & the stock price of all companies. The government not being able to pass important reforms in parliament is an example of market risk, as it will impact the whole economy & thus all the companies. Or even the Government passing certain reforms like Demonetisation would be an example, since it impacted the entire market.

Similarly, a natural calamity that restricts/disrupts the overall economy will impact all companies & is another example of market risk. Such risks are also called systematic risks – they reflect the risk of the overall equity market, and can’t be diversified away. The higher the systematic risk, the more the returns demanded by investors for equity investments compared to other asset classes like gold, fixed income, etc.

The second type of risk is the company-specific risk. This is the risk of something wrong happening specifically with the company you have invested in. For example, production stoppage due to a labour strike is a company-specific risk as it will only impact the stock price of the company experiencing it. Similarly, the resignation of a CEO having a successful track record is an example of company-specific risk, as it will not have any impact on the prices of other stocks (unless the same CEO joins a rival company!) This company-specific risk is also called idiosyncratic/unsystematic risk – or the kind of risk that can be avoided by investing in other stocks.

As such, any stock investment will have two types of risks – systematic/broader risk, and the unsystematic/company-specific risk

The Diversification Protection

Essentially, risk is unavoidable when it comes equity investing – there’s the company specific-risk, and on top of that there’s the risk with the overall stock market as well. But while risk cannot be entirely eliminated, there’s certainly one way to minimize it and protect your investments from the negative impact of such risks. That’s where that diversification principle comes in, which all experts & experienced investors keep talking about.

Suppose you have invested in Maruti-Suzuki & Tata Motors (two auto companies), and your friend has invested in Maruti-Suzuki & Sun Pharma (1 auto & 1 pharmaceutical company). Let’s analyse two scenarios:

1. Tata Motors faces labour issues: in this case, the stock price of Tata Motors will generally be negatively impacted & you’ll suffer losses in that investment. However, since Maruti-Suzuki isn’t impacted by the labour issues of its competitor, it’s stock price will not suffer. This diversification across different stocks from the same sector will help you mitigate your losses.

2. Auto sector faces slowdown: in this case, the stock prices of both your investments will be negatively impacted. If the entire auto sector is experiencing issues that result in less demand for automobiles, then both Tata Motors & Maruti-Suzuki will suffer. Since both your stock are from that sector, you will suffer losses. However, your friend’s portfolio will suffer less since it has 1 company from the auto sector, and another from the pharma sector – and the pharma sector will not be impacted by the problems of the auto sector. This diversification across different sectors will now help your friend mitigate losses.

This is a very basic example of diversification. Diversification comes from investing in unrelated stocks/assets & is the key to risk minimization.

If your portfolio has 10 banking stocks and your friend has 10 stocks from 10 different sectors, you are concentrating your entire portfolio risk to the fortunes of one sector. If any bad news regarding banks hits the market (e.g. higher capital requirements for all banks or the collapse of 1-2 banks), your losses will be very high. But your friend, who has only 1 banking stock in their portfolio, will suffer much less losses since s/he has protected themselves by investing in unrelated stocks/sectors and thus diversified away the company/sector specific risk.

The key thing to remember is that the stocks have to be unrelated, i.e. have a low correlation. Essentially, that means that the prices of these stocks don’t move together as much – if one is up 5%, the other might be up only 1% (low correlation) or even in the opposite direction at -1% (negative correlation). Over the years, academics & investors have devised many ways to create portfolios that not only seek returns but also strictly follow the diversification principle.

It provides an insurance against the very essence of stock markets – where investors constantly try to anticipate which stocks/sectors will do well in the future.

Academic research has shown that in general, one can completely diversify away the unsystematic or the stock/sector specific risk by building a portfolio of 30 stocks. In fact, the magical number of 30 stocks was even the preferred approach of Benjamin Graham, who is popularly known as Warren Buffett’s professor at Columbia University and called the “Father of Value Investing”.

benefits of diversification
The systematic risk of a portfolio starts reducing with the more stocks you have – but the benefits of diversification effectively stop beyond 30 stocks.

Protecting Against Market Risks

Note though, that above kind of diversification will only protect you against sector/stock-specific risks, and not the systematic risk of the entire stock market. Let’s continue with the above example of your portfolio (1 Maruti-Suzuki & 1 Tata Motors) and that of your friend (1 Tata Motors & 1 Sun Pharma). Now imagine a third scenario:

3. Govt. increases corporate taxes: let’s say this was done in an effort to boost the revenues of the Govt., which was finding itself slipping in fiscal deficit. An increase in corporate taxes will negatively impact all listed companies (though some more than others), and this will instantly reflect in lower valuations for all of them, including Tata Motors, Maruti-Suzuki, and even Sun Pharma (even other unrelated firms like Tata Steel for that matter). As such, the entire stock market will go down if such an event takes place. This is the systematic risk of the stock market.

How can you protect yourself against this now? The answer still remains portfolio diversification – but not the kind we discussed above. That kind of diversification invested in different/unrelated stocks, but still in stocks, i.e. the same asset class of equities. If you want to protect your investments against the systematic risk of the entire equity market, then you will have to do so by investing in assets other than equity which have a low/negative correlation with equity itself.

This kind of portfolio diversification allocates your money across different asset-classes, assets whose prices don’t tend to move together. Not surprisingly, this is called asset allocation, and is also an important part of building your overall portfolio & managing financial risk. To learn more about asset allocation & the All Weather Investing smallcase we’ve built to help you with it, read this blogpost from smallcase co-founder Anugrah Shrivastava.

In the meantime, please remember that diversification is one of the most critical aspects of investing responsibly. Which is why almost all smallcases are inherently diversified portfolios, each reflecting a different theme or strategy. Happy investing!

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The Importance of Portfolio Diversification