Is a ‘diversified portfolio’ something you need?
You may have heard the term, but is it really what you need or just a marketing gimmick? Here we tell you what it is and why you may or may not need it.
‘Diversified Portfolio’ is a term often used by personal finance experts trying to convince conventional investors to move away from bank deposits. But is it always necessary to spread out your investments? Can you not put all your eggs in one basket if you’re sure about the returns?
To answer these questions, it is important to understand two things. One, what a diversified portfolio is. And two, if such a portfolio is necessary to meet your financial goals.
Different eggs in one basket?
If you need a return of 10% per annum on your investment to fulfil your financial goals and you find an investment – say, a mutual fund – that you are sure will yield 12% per annum, then do you need to invest anywhere else?
But the truth is, with mutual funds, you can never know for sure how your investment will perform. Therefore, people often blindly follow the adage “don’t put all you eggs in one basket” and invest in several funds to reduce the risk of depending on a single fund.
Investing in several funds does not diversify your portfolio
Simply investing in several funds does not diversify your portfolio. If all your investments reacted similarly to an adverse market development – in the current context a hung election verdict, which can affect all sectors from FMCG to the airlines – then no matter where you’ve invested, you will be hit. That’s because you would have invested in different schemes that are all in the same mutual fund basket.
In this globalised world, the relationship between the assets and the market keeps changing. Equities and commodities have traditionally been more affected by macro events.
So should you diversify just because you may be incapable of measuring these relationships? The short answer is ‘no’. Diversifying for the sake of diversifying may not be of much use.
FDs in different banks is meaningless if they offer the same rate
Even if you consider Punjab National Bank (PNB) to be financially stronger than say Syndicate Bank, both are still public sector banks and are linked to the government. Moreover, a secured investment is secured regardless of the financial health of the institution.
What’s worse is that having investments in 10 banks can be very tedious and the effort involved in keeping track of maturity dates and renewing your investments far outweighs the emotional satisfaction you may derive from the apparent diversification.
Hedging one diversified fund with another is ill advised
Putting all your money in different index linked equity funds does not amount to having a diversified portfolio either. All funds linked to a particular index, for example the Sensex or the Bank Nifty, will hold the same few stocks listed on that index – 30 in the case of the Sensex – and they will yield similar returns. The only marginal difference among these funds is in their cash holdings.
Lastly, don’t invest in 10 different diversified funds. Not all 10 funds with different permutations and combinations of stocks can be accurate. If you feel a fund has got the mix of stocks and sectors right, then go for it. Alternatively, if you believe that the fund hasn’t got the right portfolio, don’t invest in it. Hedging one diversified fund with another is ill advised.
Give a thumbs down to thumb rules
Even people who understand the meaning of diversifying, diversify because they are in doubt. They invest in fixed deposits, several equity mutual funds and multiple bonds in order to minimise risk. However, investment choices on offer can be overwhelming. And when you use thumb rules to work out the perfect mix, it can prove to be disastrous. Knowing what ingredients make the right mix can be difficult. Even professionals who use sophisticated models have got it wrong at times.
Besides, managing a complex portfolio, which is a difficult and time consuming task, may be totally unnecessary. When investing, the focus should be on achieving your financial goals. And if you can achieve them without diversifying your investment, then so be it.
If you figure that you need a certain amount after 10 years and if the current bank rates are such that you can meet your financial target by investing all your money in a bank deposit then that is your best bet. That’s because you ‘know’ at the very onset the amount you will receive upon maturity.
Diversification not without its benefits
This is not to say that diversification doesn’t have any benefits. There are more than enough instances to prove that diversification has shielded investors across the world from market volatility. But that can be done only with the help of professionals, who use methods and models unknown to the average investor.
The take-home message: Do not diversify just for the sake of it. If your financial goals are being met with fixed deposits in a public sector bank, or by any other method of investment, then there should be no need to invest elsewhere.