Diversification is a strategy to reduce the risk (downside) whereas concentration is a strategy to enhance returns (upside).
In order to meet various goals in life, one needs to generate enough money such that the money is available at the appropriate times. Professional income is generally the major source through which one earns money and the surplus after taking care of regular expenses is accumulated to meet long tem goals. This surplus needs to be invested prudently.
Generally, it is seen that one gets into a profession based on education, skills, hobby, or experience. Even at times when one has got into a profession for the wrong reasons, or because there was no other alternative, over a period of time, either the profession is changed or one acquires the necessary skills, knowledge and experience.
This is possible since one puts in almost one third of the time available into the profession. It is a combination of one's time, energy and commitment that makes one do well at the job that one is doing. Concentrating all such forces into the job is also necessary since most of us cannot and do not get involved in more than one profession or job. It is through concentrating all the time, knowledge and energy into the profession that we try to maximize the result that is our earnings.
When it comes to the other factor helping us achieve our goals, the investments, not everyone has the necessary skills, knowledge or the time that one can put into the profession. In the absence of these resources, there is a higher risk of losing the money. That is where one needs to consider certain strategies, which help reduce the risk.
Diversification across different unrelated companies, sectors and asset classes is one of the proven risk management strategies. Such diversification helps one reduce the downside risk of the portfolio. Remember, individual components of the portfolio would continue to carry the same risk as earlier, but since different factors have different effect on companies in various businesses or industries or the various asset classes react differently to the changes in environments, the risk of the portfolio comes down.
Let us look at an example here:
There is a fictional hill station somewhere, which is very popular all through the year. The hill station, however, has very uncertain weather conditions. On any given day, it is either very hot, bright and sunny or very cold and you have snowfall. It is also very difficult to predict the next day's weather conditions and the same is known only afterwards.
Generally, the numbers of days of cold and hot weather are same for a year. The tourists coming to this hill station prefer to have ice cream when the weather is hot and have coffee when it is cold.
There is an ice cream parlor and a coffee house. The days when the weather is cold, the coffee house makes a lot of money, but the ice cream parlor has no business. However, on other days, the situation is exactly opposite. Every single day, the owners of the coffee house and ice cream parlor are fully prepared expecting a favorable weather condition, and every single day, only one of the two is lucky. Although, they make enough money out of the business, the daily uncertainty on account of weather is very high.
Over the years, both have wondered how to tackle such uncertainty. On one fine day, they appoint a consultant to study their situation and suggest a remedy. Through careful analysis, the consultant suggested that the ice cream parlor may install a coffee vending machine and the coffee shop may install an ice cream counter in the shop.
What has now happened is that the daily traffic of the customers gets divided between the two, but since the business flows every single day, instead of half of the days in the earlier situation, the annual income for both remains the same. The biggest benefit of such an arrangement is that they have got rid of the daily uncertainty on account of the weather condition.
This is a very simplified example of what diversification can achieve. Pardon me for the extra dose of simplicity through such a fictional example. Life is not so simple. Incidentally, to make another point using the same example, let us add a new dimension: our fictional hill station is in a high risk seismic zone, or is in a troubled order area. The ice cream parlor and the coffee shop now face another risk, which they need to tackle.
While considering diversification, the word 'unrelated' is of critical importance. Just because one has invested in thirty stocks or ten mutual funds does not necessarily mean that one has diversified one's portfolio. In the example of our hill station, both the businesses have exactly opposite effect of the changing weather.
Similarly, when one is investing in various businesses either through profession, or through stocks or through growth mutual funds, one needs to be careful in ensuring that the underlying businesses do not have the same impact of various changes that happen in the environment.
Assume an investor invests in bank fixed deposits as well as equity mutual funds. An equity mutual fund portfolio may have stocks from various industries, e.g., petrochemicals, FMCG, pharmaceuticals, automobiles, information technology, banking, etc.
When the Governor of Reserve Bank of India makes some policy announcement, the same may have an impact (either positive or negative) on stocks of banks, but may not have any impact on the stocks of IT or pharma companies.
Similarly, when the exchange rate between the Indian rupee and the US dollar fluctuate, it may have an impact on the export oriented companies (These companies export their goods or services and earn in foreign currency) and an exactly opposite impact on the companies dependent on imported raw materials (These import goods or services and thus spend foreign currency).
Thus, the equity investments are considered to be properly diversified. However, when the overall preference of investors shifts towards or against the stock markets, the stock prices of almost all the companies across the stock market fluctuate together, in spite of having different businesses.
The fluctuations in the stock market prices cause the NAVs of the mutual funds to fluctuate, but the same has no impact on the value or the interest on the fixed deposits. Thus, we can safely say that the investor has invested in two unrelated asset classes - a very important thing to keep in mind while building a diversified portfolio.
As can be understood from the above discussion, the fluctuation in the values of individual components is unchanged, but the changes in the value of the portfolio of the investor are moderated. At the same time, the returns from the portfolio would be a weighted average of the returns from the individual components. Thus, through diversification, the returns got averaged but the risk got cancelled partially.
So whether you follow the adage "Do not put all your eggs in one basket" or the exact opposite of the same "Put all your eggs in one basket and watch the basket carefully" depends on your strengths or the lack of the same in the respective areas - and this is especially true in case of investments.
There are many things in life where one can find various alternatives, but investment is an area where one can choose from different options but 'not investing' is not an option.
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