Ever heard of the phrase “Don’t put all your eggs in one basket”? This phrase is widely used in the Investment world. But what does it mean?
Diversification is a portfolio risk management strategy to reduce the overall risk of the investments which mixes a wide variety of investments within a portfolio.
Let’s say, Mr A is a businessman who owns a well-reputed Umbrella manufacturing firm. The company records a massive increase in sales in the September quarter and significantly low sales in other quarters every year. This is due to the high demand of the product in the rainy season and extremely low in others. This got Mr A to start manufacturing boots. So, here, he diversified its business for sustainable and consistent growth. Expanding into other business segments have been very common in the past and here are some examples of successful conglomerates;
- ITC-Indian Tobacco Company was a cigarette manufacturing company which has diversified into segments of FMCG, Hotels, Paperboards & Specialty Papers, Packaging, Agri-Business and Information Technology.
- Reliance Industries – It started as a textile company spreading its arm into oil and petroleum refining company, energy, natural resources, telecommunication and retail sectors. This is called as cross-sectoral diversification where different segments may or may not have benefits of synergies.
- HUL- Hindustan Unilever Limited is a multinational FMCG company dealing in consumer durables, personal care products, cleaning agents, water purifiers etc. This is a typical case of intra-sector diversification, where the company has a wide array of brands within a specific product offered to a different class of consumers.
- Aditya Birla Group – It is an Indian Multinational Conglomerate which has various subsidiaries and joint ventures around the globe in Cement, Fashion, Textiles, Metals, wealth management etc.
- Tata Sons – Tata Group, is a century-old family-driven organisation venturing into Information technology, automobiles, metals, power and energy, chemicals, electronics, consumer products etc. to name a few. Further, the Tata group of companies have geographically diversified with their presence across the globe.
These companies had started their journey in one sector and then spread their wings to more areas as part of their expansion as well as a diversification strategy.
Can we apply a similar concept to our investment portfolio as well?
Well yes, different asset classes in a single portfolio help to hedge the potential losses from the asset class/stocks.
Portfolio Diversification can be achieved in the following ways –
- Asset diversification: It can be achieved by a strategic asset allocation in equity shares, bonds and Debentures, ETFs, Commodities. Currencies.
- Sectoral diversification: It is the diversification of funds in different types of sectors like Banking/Finance, Technology, Energy, Automotives and auto ancillaries, Telecom, Metals and Mining, Pharmaceutical etc. StockBasket offers a portfolio of expert-curated baskets of stocks from various sectors in the right proportion which minimizes the overall portfolio risk as well as aligns the long term aspirational goals of the investor.
- Geographical diversification: It can be achieved by having exposure to assets of foreign countries. In India, individuals can invest in the US S&P 500 with the help of a mutual fund, thereby giving them a geographically diversified portfolio.
The three main advantages of diversification are risk mitigation, preserving the capital and lesser dependence on a single investment, thus improving overall return.
Diversification is nothing but a hedging tool, and hedging always comes up with a cost. Diversification evens out loss from specific sectors with profitable ones and vice-versa. Therefore, the overall return of the portfolio reduces when compared with a non-diversified portfolio. Therefore, many retail investors might find it difficult to replicate a well-diversified portfolio due to limitation of resources like capital, time, research and access to information.
Buying units of a mutual fund offers an inexpensive way to diversify investments.
The business environment is dynamic and hence, requires constant monitoring to minimise the overall risk of the portfolio. Diversification is a far better tool to reduce the overall risk of the portfolio.