Is Too Much Diversification Bad?

14 Apr 2021  Read 505 Views

Speak of investment risks, and every ordinary Joe & his expert uncle will tell you -- “DIVERSIFY.” But you never bother to ask, ‘HOW MUCH?’ Well, now is the time!

“The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism.” - Benjamin Graham

You know what, that sentiment bit makes investment risky. Like, imagine someone who had aggressively bet all his wealth on shares of companies in the hospitality and tourism sector before the pandemic began its spree. No brainer, he would have lost a fortune! And now you know why the wise men advise you to ‘Diversify.’

Well, that’s pure wisdom. Okay, diversify, cool. But how much? Like own 10 assets or 20 or more than a thousand? Ah, never pondered it? As yet, you probably used your rationale to find a suitable portfolio diversification mix. Don’t you feel you should add some logic to it? Like, take the calculated risk of sorts?

Well, look no further. Finology has got you covered.

Diversification - Buffet’s vs Dalio’s theory

“Don’t put all your eggs in one basket” - a single line enough to justify the premise behind Diversification. Not all of your bets can be good. To err is to humans, right? Thus, placing all of your wealth in a single asset is like playing with fire! Before you know, that sector or asset could go bust, and you may end up burning away your hard-earned money! And that brings us to Diversification.

You add some more assets to your portfolio, and then some more, and furthermore and more. The risk gets averaged, and then it’s sorted, right? Well, some wise men chose to differ.

Warren Buffet once said, and we quote, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

The essential bit that we miss out when we try to spread the risk by diversifying is that it also averages the return. Suppose there are 10 assets arranged from top to bottom in decreasing order of their returns (and risk). If you allocate your funds between asset no. 1 and asset no. 2, it essentially means you’re losing out on the additional returns that the former would have given you over the latter. But that’s reducing the risk as well, you claim?

Well, that’s true only up to a certain number of additions. Beyond that, the risk reduction would be so insignificant that it would be like giving up higher returns just to cut down negligible risks! And at times, that can be counterproductive as well!

And that’s what the likes of Buffet, Munger and Cuban have been trying to propagate. They feel wide Diversification only leads to mediocre returns. You’d as well be better off investing in an index fund then! Thus, if you can identify good businesses, parking your money in only about five of them would suffice.

However, here’s the catch... not everyone can identify good businesses! Not everyone can be a Buffet or a Munger or a Cuban, right? And that’s why, for novice investors, at least, Diversification makes sense. But back to that question, how much?

Well, a celebrated American businessman, Ray Dalio, seems to have struck a note in his “Holy Grail of Investing”.

How to diversify your portfolio well?

“Knowing how to diversify well is more important than anything else.” - Ray Dalio

Well, just so you know, this theory, in NO way, preaches blind Diversification. The idea is to ‘diversify well’. And how does one do that, you ask? Here’s how…

You’ll have to pay attention to three essential metrics:

  • The Volatility of the assets ↓ : It’s the risk or returns component of your portfolio that indicates how much low or high a share’s price can move from its average price. 
  • Return-to-Risk Ratio ↑ : Simply, if the risk you undertake is of Rs. ‘X’, this ratio will tell you how many times ‘X’ you can expect your return to be.
  • Probability of losing money ↓ : It indicates how likely you may lose your invested money in a particular combination of assets in that year.

And it’s no brainer that we would like to find a combination of such a number of assets, that the volatility is low, the return-to-risk ratio is high, and the probability of losing money is less.

And that brings us to the heart of the entire matter, i.e. CORRELATION. It is basically synonymous to the interdependence between variables. It measures how much one variable changes with a change in the other.

For instance, let’s consider shares of HDFC and IDBI banks. As they belong to the same industry, their correlation (interdependency) will be very high. Because if the financial sector trumbles, this will affect both of the companies. So, it makes NO sense if you go on adding as many companies of the same sector to your portfolio. The risk reduction will essentially be very low.

In contrast, consider shares HDFC and Sun Pharma. As they belong to different sectors, the impact of the downturn in one of them may not be reflected in the other. This is because their correlation is very low. And hence, that’s better risk-proof than owning stocks of two banks only. Owning shares, debt and gold will be a better shield than owning shares only. Get it, right?

Well, let’s focus on Dalio’s graph to understand this better.

Compare the lines with a correlation of 60% and 0%.

You can very well see that even though you go on increasing the number of assets in the horizontal axis, neither of our three metrics have shown any productive movement in the 60% correlation case.

Whereas where the correlation is nil (0%), you can reduce your risk to a fifth and your probability of losing money to a fourth of that of the 60% correlation case. And now you know why.

Thus, the lower the correlation between assets, the better is the benefit of Diversification. So, better drive home this point that, add assets to your portfolio that have very low correlation among them.

Speaking of the stock market, if you own shares of a company in the auto sector, say, Maruti Suzuki, it may not help a lot adding another from auto ancillary, like Motherson Sumi. You’d be better off diversifying both across and within asset classes.

Like if you allocate your money across asset classes like equity, gold, debt, etc., and across sectors like Pharma, IT, Financial, FMCG, etc., that’s a better guard against market volatility. And as a standard practice, try limiting your exposure to 10-15% in any particular stock or sector.

But again, back to the question of the day, how many assets to add to your portfolio? Just look at any line in the graph, and you’ll notice that after a certain number of asset additions, the decrease in risk is insignificant. Like after you add about 20 assets to your portfolio, the downward-sloping line (indicating reduction in risk) flattens and hence, the decrease in risk beyond that point will be negligible. So, there you are.

The Bottom Line

Now, you’re at a sweet spot between diversification and correlation. As you would have interpreted, about twenty low correlated assets is an ideal combination. That being said, there isn’t any perfect combination as such. You will have to skim across the inflation-growth matrix to evaluate within and across equity, gold, real estate and all other assets and find out a mix that best suits your investment objectives and risk profile.

Practically, that’ll also depend upon how much you have in your wallet. It will make little sense to go on stretching if you only get a minuscule amount of the assets. The bet on your good horses should be sufficient enough to generate adequate returns. Once that’s taken care of, 15-20 uncorrelated good bets would do.

At the end of the day, everything boils down to your homework. So, invest only after you have done the thorough research and are well convinced that it’ll work for you. And as we always say --

“Invest in what you know".

About the Author: Abhishek Sahoo | 24 Post(s)

Abhishek has a love for numbers and words alike. With a passion for finance and interest in writing, he’s blending both as a Finance Content Writer at Finology. He writes to simplify the toughest of the technical stuff for readers and tries to make the reading exercise interesting. He is a CA Final candidate and aims to pursue a management degree from a top-notch b-school.

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