Thursday, 19 July 2012

Diversify Your Investment Across Sectors

Diversification is an investment technique that focuses on spreading an investment portfolio across various stocks belonging to different sectors. These sectors generally include defensives (FMCG, retail, pharma etc.), growth stocks (high margin businesses like technology, biotechnology etc.), commodity and energy stocks.

i. Invest in a limited number of companies:
How many stocks does it take to create an ideal diversified portfolio? Unfortunately, there is no exact answer to this question. Given their large portfolio size, legendary investors like Warren Buffett and popular fund managers like Peter Lynch tend to invest in a large number of stocks. Having said that, we must also note that between 60-70% of their portfolio value is generally concentrated in their top ten stock holdings. Thus; as retail investors with comparatively smaller portfolios, we must ensure that 70-75% of our portfolio is invested in no more than 10-15 stocks. By doing this, we automatically prevent the ill-effects of “di-worsification” and we also successfully hedge ourselves against price volatility and market corrections.

ii. Ignore categories and classifications:
Most portfolio managers and financial planners use classifications like growth stocks, defensives, momentum stocks etc. while creating a diversified stock portfolio for their clients. For instance, a relatively young client’s portfolio is structured to have a majority of growth or momentum stocks which tend to be very volatile and can lead to bigger profits/losses in a small period of time. In contrast, a relatively older client is assigned a majority of defensive and high dividend paying stocks with the purpose of safety and capital retention. While this technique looks good on paper, market behavior has proven that such classifications are absurd and completely useless. Instead, an investor should diversify his/her portfolio by buying stocks across sectors and individually selecting each stock by applying the principles of value investing.

iii. Buy Index Funds:
There are a number of investors who want to invest in equities for the long term, but have neither the time nor the inclination for active portfolio management. Such investors generally invest in equity mutual funds and make money via NAV appreciation and dividend income. Many such mutual fund investors’ end up diversifying their MF holdings by buying a number of mutual funds which cover the same market and have near identical investment philosophies and performance. Such “diversification” is meaningless as there is always an overlap of stocks, i.e. different mutual fund schemes end up owning many common stocks. Moreover, it has been proven that most mutual funds don’t even beat benchmarked indices in the long term. Keeping these facts in mind, we can safely conclude that index funds/ETFs are ideal investment options for passive investors who want to diversify their holdings. Index funds are also significantly cheaper (minimal management fees) as compared to actively managed mutual funds.

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