Diversification helps - especially during downturns

My article in Mid-day Gujarati, Mumbai edition today:

http://epaper.gujaratimidday.com//epaperpdf/gmd/16022015/16022015-md-gm-11.pdf

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English translation is as under:

In almost all discussions, diversification is highlighted as one of the major benefits offered by mutual funds. It is worth spending some time on this subject. We will look at some questions: What is diversification? How does it help an investor? What is the role of mutual funds in providing this benefit to the investors?

We have heard the popular English proverb: “Do not put all eggs in one basket”. This proverb suggests diversifying across various baskets, so that if something goes wrong with one basket, all your eggs are not spoiled. Understanding this principal is critical to the success of any investment strategy.

Let us look at one critical factor impacting the earnings of various companies: price of petroleum oil. As we read in the news, the price of oil in the international markets has been falling for some time now. The fall has been quite steep and has taken most people – common men as well as experts by surprise. What would happen to portfolio positioned with an assumption of stable oil prices?

There are various businesses that may be positively impacted by the fall in petroleum prices; some may be negatively impacted; whereas some others may be neutral.

Even when the impact of drop in oil price may be negative for some business, many businesses are resilient to recover after the initial setback only to resume long-term growth after some time. However, one may not be too sure in the short term.

In such a case, if someone has spread the investments across all the three types of businesses – those that may be positively impacted, those that may be negatively impacted and those that may be neutral to oil price changes – the short-term impact may be quite low. This is a huge benefit of diversification.

Another major advantage flows from the above. What if some companies are unable to recover from the short-term impact and eventually go out of business? Well, is it possible to identify such companies in advance so that one can avoid these completely? The fund managers and analysts try to do exactly the same. However, with so many factors involved, there is a possibility that their judgment may be wrong sometimes. Here again, a diversified portfolio is able to withstand the vagaries of short-term changes.

The above discussion could be true for individual companies as also for an entire industry.

At some time, euphoria may set in the market taking stock prices to sky-high levels. We have often seen that such a rally primarily driven by one or two sectors that take the lead. Given below is a chart showing market price movements during the technology boom of 1998-2000.

In the above chart, the blue line shows the movement of technology sector funds, whereas the red line represents that of diversified equity funds. One can easily see that the technology sector prices move much more than the diversified sector – in both directions – up as well as down.

Point to point, the technology sector ends higher after a three year period than the diversified funds. While an investment of Rs. 1 lac in the diversified funds would be worth Rs. 1.07 lacs; that in technology sector funds would be worth Rs. 1.75 lacs. However, the bigger question is: how many investors entered the funds around September-1998 (the start of the period in the above chart) and how many entered around February-2000 (when the prices reached the peak levels)?

Experience and data suggest that majority of people entered closed to the peak than the bottom. This resulted in regret. Between February-2000 and September-2001, while diversified funds lost by 51%; the technology funds lost a whopping 86%. Recovering from such a loss would take a while.

Putting the above numbers in perspective:

Let us say, someone invested Rs. 10,000 at the peak of the market in February-2000 in a diversified fund. The value of the investments would be around Rs. 49,000 since the prices fell by 51%. Now, to recover the losses and to break-even, the fund vale has to rise by Rs. 51,000. This means the fund price has to more than double (return on investment of roughly 104%).

On the other hand, an investment of Rs. 1 lac in technology sector would have been down to Rs. 14,000 by Spetember-2001. To recover the losses and to breakeven, the value has to rise by Rs. 86,000. This is a growth by more than 6 times (Rs. 86,000 on a base value of Rs. 14,000 or 614% return on investment).

Which do you think is possible? Which can happen faster? A concentrated portfolio is likely to see more volatility than a diversified portfolio.

There is a story about a man who had four sons. All four were almost always fighting among themselves. The father wanted to teach them a lesson. He gave each one a twig and asked to break. All could do it very easily. Then the father collected a number of twigs and tied these with a rope and then asked his sons to break the bundle of twigs. They failed. As kids, we were taught, “there is strength in unity”. This was nothing but a diversified portfolio that could withstand the external force better than individual twigs could.

Happy diversifying and happy investing to all.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.