Diversification is a fundamental concept of modern portfolio theory that has been drilled into our consciousness since the day we started thinking about investing.
Don’t have all your eggs in one basket, contain portfolio risk by investing into a basket of securities across asset classes. The benefits of diversification are contingent on the securities not being well correlated with one another.
People understand diversification reasonably well in the context of
- Asset classes (bonds, equities, cash, real estate, gold and so on)
- Geography (India, Other Asian markets, Developed Markets)
However, there are a few other facets of diversification that one needs to appreciate.
Diversification is overrated in the context of wealth creation
I am yet to meet an investor who created substantial wealth through a diversified approach. Concentration is what creates wealth, diversification is what preserves it. If you are a 60-year-old investor who is already wealthy, diversification is the way to go. If you are a 25-year-old investor who wants to create wealth diversification is sub optimal in your journey, at least in the first leg.
If you are reading this blog, you most likely do not fall into the first category.
All entrepreneurs by definition are concentrated investors. They have an overwhelming majority of their net worth linked to their business. Look at the Forbes list of the richest people, all the first-generation folks in there are entrepreneurs. If this large chunk of their net worth goes on to do well, we see a multi-millionaire emerge. Else the guy is toast.
If you are a 25-year-old investor with an annual salary of 10 lakhs and a net worth of 10 lakhs, you need to have a high allocation to growth assets and a high annual compounding rate to create some wealth by the time you are 35 years old. You aren’t going to get there by buying ETF’s and mutual funds, that might create some wealth for you by the time you are 50 years old. Once again, if you are reading this you likely have loftier aspirations in this aspect of life.
I did not compound my net worth at 30% p.a. over the past decade by buying an index fund or by holding 50 stocks.
Diversification is underrated in the context of stock picking
Diversification doesn’t just mean a balanced sector allocation and spreading bets across market cap. Other aspects that can make a difference are
- Emerging business model Vs mature business model
- Secular Vs Cyclical
- Domestic economy focused Vs Export focused
- Undervalued or Fairly Valued or Fully Priced in
- Professionally managed Vs Promoter run
- Businesses in the same value chain (Auto Ancillary Vs Auto OEM)
- Big fish in a small pond Vs Growing fish in a big pond
- Businesses at various stages of stock discovery
Buying all high quality but expensive businesses across sectors isn’t adequately diversified in my opinion. If the market for some reason were to tilt toward value investing over the next few years, such a portfolio will suffer over the medium term even if it does well over the long term.
Buying only well-known stocks with heavy FII ownership can be disastrous if FII’s turn bearish on India for some reason. In March 2020 a 100 Cr FII sell order sent Kotak Bank lower by 10%. Not all market rebounds will be as sharp as the one we saw in 2020, stock prices can languish for years after a contraction.
Portfolio construction and risk management is more complicated than it appears to be, this takes up almost a third of my fund management time. Any decent investor in India can pick a few winners, how to put them together into a portfolio that can perform well across market cycles is a different skill. Investing narratives in India rarely focus on this skill, we all want to celebrate rock stars who make 100x on a single story, even if the rest of their picks are junk.
Contrary to what one may believe, this does not counter the need for a concentrated portfolio in the wealth creation phase. One can have a 10-stock portfolio, yet be reasonably diversified across some (if not all) of these facets.
Diversification has lost some of its sheen in the MMT era
Modern Monetary Theory (MMT) has sent correlations across asset classes higher compared to historical averages. There have been market corrections where all asset classes (including gold) go lower at the same time. When central banks hold interest rates at low levels and engage in asset purchases, all asset classes can move up simultaneously.
Markets across the world within the same asset class have gotten more interlinked and correlated. When Modern Portfolio Theory became the mainstay of investing, the world wasn’t this interconnected. Rarely did one have a situation where global equity markets would move in lockstep and fall 3-4% on the same day. Go back to March 2020 again, count the number of sessions where the NIFTY 50 moved in a direction opposite to that of the Dow Jones Index. If you thought holding Indian equities and US equities was diversification, that thesis was proved wrong almost daily. You just had to see what the Dow Futures were doing to get a sense of what the NIFTY 50 would do.
Historical correlations can stop working at precisely the time investors need them to work the most. Every bout of market volatility since 2008 has proven this time and again.
Suggest that you quickly run through the publication The Decade that went by to get a sense of how the world has changed over the past decade. Fundamental portfolio theory concepts still work, just that some of them work to a lesser extent in the current context.
Implications
Think deeper about diversification as a stock picker. When you feel you have done enough, think about more aspects. Obsess over risks, that is what investors can control to some extent. Reducing risk can never be a precise endeavor. Complicated math gives the illusion of precision, especially if one does not understand it. Read about how LTCM went bust in the US, they had very precise models that they thought could never go wrong. In another time people thought that the Titanic could never sink either.
If you are working for a Tier-1 employer who has been generous in giving you ESOP’s, your portfolio may carry more risk than you think it does. If the business goes through a tough period it can impact both your employment prospects and your net worth. Does not mean that you go out and reduce exposure (remember concentrated exposure to a good pocket can create wealth), just that the rest of your portfolio construct needs to take this into account. I’ve seen portfolios where the bloke is employed with a tech company, has more than 60% of this net worth riding on the ESOP valuation and then goes on to buy the FAANG stocks in his public equity portfolio. And this is an IIT, Ivy League graduate with a 780 score in GMAT.
Don’t fall for sales narratives that harp on how a particular approach to stock picking is superior to all other approaches at all times. Everything is a function of time and place; today’s rock star can become tomorrow’s punching bag. We have seen this cycle before; this time will be no different.
It is worth exploring if you can calibrate to the market conditions when they change significantly, there is no harm in being active on both the asset allocation and portfolio construct fronts. The objective should not be to maximize or to optimize return (tough endeavors) but to minimize regret at all times. If your asset allocation was the same when the NIFTY 50 was at 8000 as it is today when the index is at 14300, you may need to evaluate a few things. The portfolio construct needs to be different too, not just the asset allocation template. Different themes work at different stages of the market cycle.
Every bull run forces even the best investors into a few mistakes, we cannot avoid those. What we can do is to reduce the extent to which these mistakes can set us back, this is the real value that diversification brings to the table. Greater optionality and the ability to survive a tough day to fight another day.
