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Beginners’ guide to diversification

Some were made by different entities of the same promoter group, while many produced in the same company itself.

Published: 19th July 2021 09:54 AM  |   Last Updated: 19th July 2021 09:54 AM   |  A+A-

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For representational purposes (File Photo | AFP)

Express News Service

If you look back into the history of our country, the earlier closed nature of the economy and licensing of almost all products by the government led to large business houses becoming manufacturers of many types of varied and unrelated products.

Some were made by different entities of the same promoter group, while many produced in the same company itself. These businesses are called conglomerates.

They were the need of the hour, as whichever company got the all important license, it started to manufacture the product, irrespective of any synergy with existing businesses.

However, such unrelated diversification has lately been referred to by consulting firms as 'Di-worsification' and many such conglomerates have restructured to separate out specific businesses into different companies to bring the required competence and focus for each business.

However, the same cannot be said for investments. Diversification in the context of investments is more like not putting all your eggs in the same basket. While diversification does reduce the potential for returns, it also reduces the risk that you carry, in case things go wrong. 

In the example of eggs in a basket, maximum returns are by carrying all in just one trip. However, if something goes wrong during that one trip, you lose all the eggs, and that may not be an acceptable 
option. Fortunately, as you diversify your investments, the risk falls much faster than the potential for returns.

The first level of diversification that needs to be done is in terms of asset classes. These typically include Debt, Equities, Gold, Real Estate and for the more informed private equity, venture capital, 
angel investing etc.

Each one of these asset classes carry their own risks and return potential as per their unique characteristics. Debt has the lowest level of risk associated with it. The only risk there is of default, that is if the borrower does not repay the interest and/or principal in time.

If you are investing in savings schemes sponsored by the government or in deposits of reputed banks, this risk can be deemed to be negligible. Other forms of debt including debt mutual fund schemes, corporate deposits, real estate backed papers etc. have progressively more risk than the simpler products.

Blending equities investment into your investments changes the risk-return characteristics of the overall portfolio significantly.

That is why you should be sure that you can take temporary downsides to these investments and have a longer term horizon so that sharp movements both up and down have time to normalize themselves. Equities investments can be done through mutual funds, portfolio managers and directly through purchase of individual stocks.

The only advice I can give you is: do not get carried away with stock tips. If you do intend to invest directly in stocks, be certain that you can do the necessary research and monitor your investments continuously.

While there are several forms of owning gold these days. You can buy coins, or for larger amounts, biscuits, or even invest in Gold bonds issued by the government of India, which provide a price match at maturity as well as token yearly interest, the fascination of Indian women for gold jewellery means that unless you have a fair sum to invest in this asset class, best to let the lady buy what she likes.

A friend narrated his wife's reaction to buying Gold bonds as "What am I going to do with these certificates, I can't hang them around my neck when I go out next".

Real estate ownership in terms of your own house is not to be counted as investment. You live there and should feel blessed for the same. However, purchase of additional real estate, most probably as a second house/flat needs to be done even more carefully. Real estate investments are lumpy and very illiquid and you must be certain that you will not require the money from its sale for any emergency or near term objective like higher education of children, weddings etc. Desperate sale of real estate may cause significant loss during the sale transaction.

In summary, diversification, both in terms of asset class and in terms of the instruments that you buy within the asset class is extremely important while attempting to create a long term structured portfolio of investments. You will get a better handle on this as you gain experience. In the meanwhile, talk to an investment advisor you can trust. Be aware that your portfolio will be unique as are your requirements and your personality. There is no copy and paste option here!

(The author is the founder of Five Rivers Portfolio Managers and can be reached at pankaj@5riversindia.com)



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