Share Market Basics for Beginners – Stock Diversification can be a trap

Asset allocation is a must for any investor. However, stock diversification may not reduce the risk as much as most investors think.

‘Share market basics for new investors’ is a series of articles written to explain the basic fundamentals of the share market. In these articles, we will talk about the “street smart” knowledge investors need to be successful.

Isn’t your immediate reaction, “Are you nuts? Everyone in the world preaches diversification!!” Well may be, but let’s spend a few minutes to hear my side of the story.

It was 1998. Although I had been investing for about 8 years, I hadn’t really thought too much about systemic stock diversification. I was meeting with my stock advisor at a large brokerage house on Wall Street. My first conversation on diversification was with him, a man in his late 50s, who had spent his entire life in the stock market. At that time, I was heavily invested in my company stock. My company was doing great. The stock was  flying high – the dot com bust was yet to come.  Like a seasoned pro, my advisor tried to explain to me the benefits of stock diversification. I told him that diversification sounded more like dilution of returned. I asked him if diversification would provide returns similar to what I was getting from my investment in my company stock.  He convinced me to divest some of the company equity, but failed to convince me to buy the mutual funds his company offered.

Recommending diversification so that novices can reduce risk is like recommending that novice skydivers strap a pillow to their backsides to “reduce risk.” Wouldn’t it be more helpful to advise them to avoid skydiving until they have learned all about it? Novices should not be investing; they should be saving, which means acting to protect their principal, not to generate a return when they don’t know how.”  – The Elliott Wave Theorist (April 29, 1994)

My advisor was right that staying invested in one company is not the right strategy (my company stock went on from less than $10 to over $100 and then to less than $5 before being sold to a competitor). However, I still believe that diversification via mutual funds do not work.

Diversification is a trap

Flip side of stock diversification

Diversification works when the asset classes have a very low correlation. For example, if the stocks go up, the real estate or gold may not go up at the same time. Investing in such diverse asset classes helps to reduce certain risks.

However, diversifying within the stock market by investing in small cap and large cap stocks do not reduce the risk by much. In general all stocks are heavily correlated to the stock market. If t the market goes down, most stocks go down and vice-versa. Need proof? Check out the performance of any stock or mutual fund during the 2008 crash. Regardless of the country, regardless of the stock exchange, regardless of the classification of mutual fund, regardless of the economic condition in any country, majority of stocks and mutual funds lost value – some more than others. There was no place to hide.

Harry Markowitz introduced the idea of diversification into investing back in the 1950s. But it doesn’t work is clear from any number of studies over the past decade which show that the correlations between stocks change when markets move up or down. If the market suddenly plunges downward, you would hope that your well-diversified portfolio, invested as it is in stocks that tend to move unlike one another, would be OK. But when markets move significantly down (or up), it turns out, the correlations are no longer what they were.

Now let’s apply common sense to this problem. Take a look at the performance of NIFTY or SENSEX over a large period of time. You will notice that investing in either would have produced a return of about 14% – give or take 2% depending on how the return is calculated or when the actual investments were made. If the average fixed deposit returns about 10%, is it really worth taking the chances for the additional 4%? The reason for this paltry return is the stock diversification or dilution caused by the components of the index. Now compare this with the return of some great companies like TCS, Infosys, or ITC. These companies have made their investors very rich. At the same time, there have been companies like Satyam and NSEL – hit by scams where people lost their shirts.

Diversification is protection against ignorance. It makes little sense if you know what you are doing.” – Warren Buffet

Warren Buffet calls it the “Noah’s ark investing”. He said, “I can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing – you end up with a zoo that way. I like to put meaningful amounts of money in a few things.”

So what is a retail investor supposed to do? Here is one option, an option that seems to work for me –

  1. Become an active investor – educate yourself
  2. Identify good companies that offer growth at a reasonable price
  3. Avoid IPOs for two reasons – there is just not enough data to figure out if it is a great company to own, and two years before the IPO, the companies are usually busy window dressing the company
  4. Learn to filter out the day-to-day noise. If a stock is already in the news, most likely it is too late to buy it
  5. Build your long term portfolio, one stock at a time
  6. Have some investments in mutual funds and bonds too

Keep in mind that by investing in different companies, the only risks you are reducing are the ones associated with each company (or sectors). Some of the examples are – change in the management team (INFY), devaluation of INR (IT companies gained), high debt and increase in interest rates (J P Associates)  etc.  It doesn’t protect you from the risk of the economy. For example, when the Indian economy was growing at sub 5% GDP, it impacted the stock price of almost all companies.  When the world markets crashed in 2008, it impacted majority of the stock prices all over the world. Similarly, when the NIFTY when from 5500 to 8100 from Oct 2013 to Oct 2014, stock prices of almost all the companies went up.

Here’s what the Securities and Exchange Commission (SEC) of USA and Forbes  have to say about diversification.

In my book, ‘Stock Picking Made Easy’, you will find a simple strategy to identify great companies at reasonable valuations in the Indian Stock Exchange. Identifying great companies at the right time is the key to long term wealth creation.

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