They say not to put all your eggs (or in context of this image, strawberries) in one basket. This holds true more in the stock market than any other place. The stock market is a place of uncertainties. Though you can predict the movements of stocks to an extent, using either fundamental or technical analysis (know the exact difference here), there are always forces which are not in your control and can shock even the most seasoned market participants. It is hence wise to be rational and not put all your eggs, or strawberries, in one basket no matter how confident you are of your analysis.
What is diversification?
As the name suggests, diversification is a way to “diversify” or broaden your portfolio into various different investments so that you can manage the uncertainties of each instrument.
It is basically a risk management technique where you choose many different instruments so you don’t lose all your money on one bad move.
So, if you participate in the stock market, it would be wise to not put all your money in one single stock but choose different stocks in different sectors so that one drawdown in one stock may be balanced by the others. The key is to not choose similar companies which may all fall together, for eg. 5 cement companies or 10 tech companies, but a varied basket, say 1 retail company, 1 tech company, 1 utility company and so on…
But what happens, you may ask, when the full market falls like during recession or during covid crash of 2020?
Often due to external factors, it may happen that the entire equity segment may fall. So the natural solution to that problem is diversifying across not just stocks, but also various asset classes like debt and equity.
A general rule of thumb used to calculate allocation between debt and equity is your age. Say our age is 26, allocate 26% of your money into debt and the rest in equity. By the age of 50, this will go to 50-50. This is only a guiding principle and not a rule, meaning you don’t have to rebalance your portfolio every year. It doesn’t even need to be exactly that and you do not have sell your good equities to rebalance. But it helps you atleast focus on debt as you grow older. You can even use hybrid mutual funds that invest in both debt and equity. But I would advise to use individual debt and equity instruments to actually diversify.
There are several debt instruments to choose from such as corporate bonds, government bonds, fixed deposits, debentures, provident funds, certificate of deposits, etc. There are also debt mutual funds just like equity mutual funds that can help you start. You may also use other investment options like gold and real estate based on your capital, know-how about the sector and preferences.
Pro-tip: The key to diversification is use sectors and instruments, which are not just independent but also mutually convergent, meaning asset classes which have opposite movements. When one goes up, the other goes down, and your portfolio remains relatively stable.
Can you diversify too much?
You most definitely can.
I generally see only 2 types of people- those who do not diversify at all and those who do it too much.
If you are the kind with 100 stocks and 15 mutual funds, you have definitely diversified way too much to the point that you nullified the effect of any instrument in your portfolio. Even if one of your stocks goes 10x, it might end up moving up your portfolio only by a few percentage points. If you diversify so much, you’d rather have just one index fund and save yourself the hassle of buying, selling and managing so many assets. Way too many instruments are also extremely difficult to handle and you may miss the crucial points where you should’ve sold or bought more of your assets.
The key is to give each of your investments just enough weightage that the growth in one can actually impact your overall portfolio.
What is the ideal amount?
You should start with a bird eye’s view of your overall net worth first. Consider all asset classes you own, including real estate, gold, etc. (people often forget provident funds and insurance with returns) and then decide what should be the remaining money in equity or debt or gold.
If you own mutual funds, I suggest going with not more than 4. A good allocation would be 3 in equity and 1 in debt. If you own hybrid funds, don’t own individual equity or debt funds.
An ideal number of stocks would be 10-20. More than that and you will lose sight of all. You don’t have to buy all your stocks right away. You can add them as you study them over time or when the conditions are right. They also don’t need to have the same allocation- you can always put more money in things you trust or know more.
Bottom line:
Diversification protects you against market uncertainties and help you keep your portfolio relatively stable even during extreme volatility. It is good to diversify not just between different stocks but also different asset classes. Allocate in assets you are comfortable with.
Again remember, these are all guiding principles. You can diversify more or less based on your capital and knowledge. The good thing about long term investing is that good assets will automatically give better returns and grow faster than rest of your portfolio and take up a bigger piece of your pie, which is good. Don’t rebalance just for the sake of it.
As Charlie Munger often says, “Diversification is for idiots.” This is true to an extent. Don’t go overboard and don’t work against your gut. Diversification is only a risk management technique, so you decide how much risk you are ready to take.
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