This came to us as a question from a Scripbox member.
Q: Would be very helpful if you could help me understand what isand overdiversification of . When does becomes over ? Are there any advantages/disadvantages, etc. ?
A: This is a great question becauseis a term from theory which is not completely understood by investors. The most common metaphor for is not having all your eggs in one basket. The theory definition of it is slightly different.
Let’s say a farmer has a 100 eggs to take to the market. He puts them into 4 baskets – 25 each. If he drops a basket, he only loses 25 instead of all 100. This is managing a type of risk called concentration risk. The more baskets he can put my eggs into, the better it is. Of course, there is the added cost of having to buy many baskets! Which may become more than the cost of eggs that he is protecting.
Similarly, If I put all of my money into one single, I also face concentration risk. I can reduce this by putting my money into 2-4 similar .
If multiple baskets is reducing concentration risk, what is diversification?
is about achieving a preferred risk/return objective by constructing a of non-correlated .
In plain English, ais where
1. you combine more than onecategory
2. the return and risk characteristics of your chosencategories are different (non-correlated).
3. the sum total of return and risk matches what you want to achieve/ are okay with.
This is done by choosing the right mix of( ).
For example: You would return expectations and price volatility. By holding, say, 40% of your in debt funds you can reduce the overall risk (volatility) of your .your by in both and . They each have different
You could alsowithin Equity by allocating your money across Large cap, Mid cap, Small cap etc. The correlation here would be higher than that with Debt.
Within large cap, you would pick stocks from different sectors (non-correlated) to create alarge cap portfolio.
Investment managers construct sophisticated models and track the risk/return characteristics of asset classes and securities (stocks and bonds) to construct their .
In plain English, a diversified portfolio is where you combine more than one investment category and the return and risk characteristics of your chosen investment categories are different. This is done by choosing the right mix of asset classes (asset allocation).
Your job vs fund manager’s job
At this time it is also apt to understand the difference between what you should focus on and what yourdoes.
As a consumer, your job is to decide on the appropriatefor your objectives and thereafter pick the that map to your chosen .
Amanager’s job is to create a of stocks that deliver the objective of the . So if it is a Large Cap , the must pick a of large cap stocks that achieve the optimum balance of risk and return.
While diversifying, should I worry about the stocks a mutual fund is holding?
Yes and No.
Yes, to the extent the objective of thematches your . This has become easier after July 2018. A must identify itself as belonging to one of the 36 categories by objective and then must stick to it. So all you need to do is to pick the asset class of .
No, because the actual stocks held should be left to the discretion of the. Their performance track record would reflect whether their strategies are successful or not.
Mostly I would describe this as buying too manywithout actually diversifying hoping many baskets are better.
When you are making a conscious choice of asset classes to, in too many relative to the size of your would be over . A Rs one crore may need five to six asset classes but a Rs one lakh may be OK with just two.
a. Mosthave some degree of correlation. So the idea is to seek out with higher non-correlation
b.DOES NOT increase returns. Indeed it reduces returns as at any given time, some of your are moving one way and some are moving the other way.
The baskets of eggs analogy extended to diversification
This would require that all the baskets are not the same or are being transported differently.
Let’s consider that the farmer was transporting some baskets by truck and the others on a bike (with his nephew holding the baskets on the rear seat). With this, the probability of the baskets dropping is different depending on the mode of transport. The farmer now has to decide where he should put his eggs. Carrying them by bike is cheaper but riskier while transporting them by truck is more expensive but safer.
The farmer can choose to transport some baskets by truck and the others by bike. This reduces his overall risk due toamong the modes of transport. And the reduction in cost would increase his profit.