What is Portfolio Diversification?

Portfolio Diversification

If you are a budding investor, got some spare money and thinking of investing in stock markets and for the first time you walk into broker’s office, tell your broker about your interest. The first thing that broker would be telling is “diversification or portfolio construction”. If you know the word its well and good, but if you don’t have any idea about it then you will be puzzled. You would have read that shares of your favorite company (e.g.: Infosys, Reliance or TCS) are trading well, so you tell your broker that you want to put all your money into stocks of that company. For a moment your stock broker will look at you as if you have fallen from sky, it’s because people living at the stock markets believe that if you don’t diversify then there are very less chances of you surviving in the market. Now, is it always necessary to have a diversified portfolio…..??? If yes then how much should an investor diversify? Are there any side effects of this so called diversification?

Being an investor you must have heard this particular word more than thousand times and I’m also sure that you would have read a lot on this topic, but most of the times the investors do not get the full meaning of portfolio diversification. If you ask what’s diversification most of the answers would be “having shares of many companies” or if he is an investor with bit of knowledge he would say “not putting all your eggs in one basket”. I would agree with the second person to some extent, but if asked to elaborate he will switch over to the first definition, which is incomplete. Diversification does not only refer to holding shares of different companies but holding the securities of many companies, fixed income securities, money market instruments etc, in what proportion we allocate or invest in these avenues depends on our risk taking ability, knowledge to analyze the economic conditions, companies etc.

Advantages of portfolio diversification

Let’s have a look at some of the advantages of portfolio diversification

Disadvantages of Portfolio diversification

Over-diversification and under-diversification

Overdoing something is bad and under doing is not an exemption. This holds good in case of diversification. Over diversifying and under diversifying can harm your portfolio. Some of the reasons why investors go for over diversification are;

Reasons for portfolio diversification

Portfolio Re-balancing

This is also called as portfolio evaluation and portfolio revision. Most of the investors must be wondering as to why there is a need for revising the portfolio. For example last year you had invested 75% in shares and 25% in bonds and your portfolio had given you returns of 15%. These figures look good but is it good to continue with the same portfolio…..??? experts say that investor must revise his portfolio. Some of the reasons that are given in support of their view are;

Effect of portfolio diversification

Stock markets go through phases such as Bullish or Bearish, and as the phase change there are changes in the earnings and stock prices. An investor can capitalize on these phases to revise his portfolio, so that changes that occur in stock markets do not have a greater affect on his earnings. Experts have said that only way to protect yourself is to tilt your portfolio towards shares when there is a bullish trend and towards fixed income securities such as bonds, debentures etc during bearish phase.

See Also: How To Choose Your Mutual Fund Portfolio?

After all this discussion the question is how much to diversify? The answer for this question depends on certain variables which must be decided by the investor.

Let’s see what will be the effect on your earnings if you falter in diversifying your portfolio. Let’s take an example of three investor friends Ajith, Ramesh and Randev who have invested an amount Rs. 10,000 in stock market and have diversified their portfolio. Ajith is a risk averse investor, Ramesh is an investor with good analytical reasons and moderate risk taker and lastly Randev is an aggressive investor.

Returns from different avenues

The dividends that are paid to shareholders depends on the profits made by the company. In case company doesn’t make profits then it doesn’t pay any dividends as is the case of companies P & Q in this case

Returns of Ajith will be

Returns=3000(16%) + 7000(10%)
=1180 rupees

Returns for Ramesh

Returns=4000(16%)+1000(10%)+1000(14%)+4000(10%) = 1280 rupees

Returns for Randev

Returns=3000(16%) +1000(10%) +1000(14%) +1000(4%) +1000(0%) +1000(0%) +1000(8%) =840 rupees

From the above given example it is clear that over diversification and under diversification of investments is harmful.