Mutual Funds Day 37: The Concept of Diversification
Diversification means holding multiple assets at the same time so that you do not lose heavily when few of those assets lose value. If you look at human history, you will quickly agree that “Diversification” is not something that we do naturally.
A carpenter used to be a carpenter, but he does not diversify into masonry to future-proof his career. A cobbler used to be a cobbler, he does not venture into farming as part of diversification.
People used to do one thing at a time, and that too with perfection. Only if they fail at that, do they think of doing something else. The concept of multi-tasking, and putting your feet on multiple boats are by-products of modern-day management gurus.
Modern-day businesses are fragile, job opportunities are unpredictable, all opportunities are not commercially viable and then the government reforms can make or break an enterprise. Since the uncertainty is rising, it is always better to have your eggs in multiple baskets so that even if 2 or 3 of them break — you still can make it big with the surviving ones.
100 years back, the concept was to have all your eggs in one basket and then guard them with your life. Now, the concept is to have 1 egg in 100 baskets and trust the owner of that basket to protect your egg.
The backbone of Mutual Funds is built on “Diversification”, the fund manager pools money from investors and then invests in multiple companies so that even if a few of them go bankrupt, the returns on the others will offset the loss.
When you invest Rs10000 through a mutual fund, the AMCs may allocate this money in the following way
- Buy HDFC Bank for Rs2000
- Buy RELIANCE for Rs2000
- Buy ITC for Rs2000
- Buy TATA STEEL for Rs2000
- Buy INFY for Rs2000
So, the AMC allocated the funds equally to 5 different companies. The biggest advantage here is that these firms are from 5 separate sectors with minimal business overlap. The chances of all the businesses failing at the same time is a low probability event. We could say with a higher confidence level that the chances of a huge capital loss are limited to an extent.
The biggest disadvantage of diversification is that you lose out on huge capital appreciation. For example, if HDFC Bank goes up by 20% whereas the other stocks stay flat — then you would have made more money if you invested in HDFC Bank’s stock rather than diversifying.
Let me break down that math for you.
If you had invested Rs10000 in HDFC Bank, and it went up 20%. Then your new fund value = 10000 + 20% * 10000 = 12000.
If you invested Rs10000 across 5 stocks, of which Rs2000 went into HDFC Bank, then the new fund value (considering other stocks remained flat) = 10000 + 20% * 2000 = 10400.
Case 2: If HDFC Bank falls 25% and the other stocks remain flat, the final numbers will be
- Direct HDFC Bank purchase, Rs10000–25% of 10000 = 7500
- Via Mutual fund, Rs10000–25% of 2000 = 9500
You may notice that diversification is a big boon if the prices are falling as the impact of losses on any one stock will not affect you that much.
Diversification is a broad topic and we may need to break it down into 3 or 4 chapters to explain it in detail. We discussed the conceptual part in this chapter, and we will talk about correlation, beta, and portfolio diversification in subsequent chapters.
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