Mutual Funds Day 37: The Need for Diversification
We discussed the concept of diversification in the last chapter. If you have not read it, please do so.
https://viswaram.com/mutual-funds-day-36-the-concept-of-diversification-862bf544e2ac
The current chapter will look at why we need diversification in life. Diversification has its roots in uncertainty, a layman cannot predict the future, so the next best thing is to spread his wealth in multiple asset classes, believing that one of them will pay off.
Imagine you are going on a 5 day trip to an island that has no food source. You are allowed to carry 5 quantities of fruits. How will you approach this situation?
- Carry 5 bananas?
- Carry 1 each of bananas, apples, oranges, pineapple, and watermelon.
I would always prefer to go with option 2 as bananas may go bad on the 3rd day & I might stay hungry for the last 2 days.
Suppose you were to go to a zoo and meet Mr. Chimpanzee and you were allowed to carry 5 quantities of fruits, what would you do?
I would go with option 1 and carry 5 bananas as I know that Mr. Chimpanzee likes bananas and would be happy to eat them.
Real world investing has a lot of similarities with the two examples quoted above. If you are sure, you can make a direct decision. If you are unsure, the next best option is to buy a basket of assets.
Diversification is the art of owning multiple assets when the investor is not sure what asset class will outperform in the future. Usually, the fund manager overseeing the diversified mutual funds will pick assets that are negatively correlated, meaning if one of the assets loses value, the other one stays the course.
If you are a domain expert, a learned individual, or a genius — you get the maximum bang for the buck if you invest all your funds into a specific asset class. There is no need to diversify and lose out on multi-bagger gains.
Mutual funds are known for their diversification, the fund manager buys almost all the stocks and holds them in a specific ratio. The belief is that in the long run, few of them will outperform and most of them will underperform. The stocks that outperform will give returns of 10X, 20X, etc. (There are real examples of stocks that went up 34000% in 10 years). And the maximum the underperformers can lose is 1X.
The fund manager carefully rebalances the mutual fund, weeds out the losers and keeps adding on to the winners. This is quite difficult at an individual level due to the three basic issues
- You need to be highly skilled to make the changes on time without slippages.
- You have to pay taxes.
- You have to pay brokerage & charges.
A mutual fund house has the above 3 advantages by default. They hire a professional fund manager and they do not pay taxes on transactions as MFs are identified as pass through vehicles. Their brokerages & charges are the lowest in the industry due to volumes.
So if your idea is to own a diversified asset class — mutual funds are the way to go. On the other hand, if you have strong confidence in what stock is going to outperform — then direct equity investing is the way forward.
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https://viswaram.com/mutual-funds-day-36-the-concept-of-diversification-862bf544e2ac