Continued from last issue

Last time in this column, we introduced mutual funds. We talked about certain benefits that mutual funds offer to the investors from convenience point of view. Apart from those benefits, a major benefit is diversification. What is diversification? How is it important to investors? "To diversify" means “to distribute over a wide range of types or classes”. In the parlance of investments, diversification means the process of distributing one's investment funds over a wide range of options. The options could represent different companies, different industries, different countries, different asset classes, etc.But why should one diversify? Is there a benefit to that? Well, let us go to a hill station to understand the benefits of diversification. This is a fictional hill station and we are using the example only to understand a concept.

There is a fictional hill station somewhere, which is very popular all through the year. The hill station, however, has very uncertain weather conditions. On any given day, it is either very hot, bright and sunny or very cold and you have snowfall. It is also very difficult to predict the next day's weather conditions and the same is known only afterwards. Generally, the numbers of days of cold and hot weather are same for a year. The tourists coming to this hill station prefer to have ice cream when the weather is hot and have coffee when it is cold. There is an ice cream parlour and a coffee house. The days when the weather is cold, the coffee house makes a lot of money, but the ice cream parlour has no business. However, on the other days, the situation is exactly opposite. Every single day, the owners of the coffee house and ice cream parlour are fully prepared expecting a favourable weather condition, and every single day, only one of the two is lucky. Although, they make enough money out of the business, the daily uncertainty on account of weather is very high.

Over the years, both have wondered how to tackle such uncertainty. On one fine day, they appoint a consultant to study their situation and suggest a remedy. Through careful analysis, the consultant suggested that the ice cream parlour may install a coffee vending machine and the coffee shop may install an ice cream counter in the shop. What has now happened is that the daily traffic of the customers gets divided between the two, but since the business flows every single day, instead of half of the days in the earlier situation, the annual income for both remains the same. The biggest benefit of such an arrangement is that they have got rid of the daily uncertainty on account of the weather condition.This is a very simplified example of what diversification can achieve. Pardon me for the extra dose of simplicity through such a fictional example. Life is not so simple. Incidentally, to make another point using the same example, let us add a new dimension: our fictional hill station is in a high risk seismic zone, or is in a troubled order area. The ice cream parlour and the coffee shop now face another risk, which they need to tackle.

While considering diversification, the word “unrelated” is of critical importance. Just because one has invested in thirty stocks or ten mutual funds does not necessarily mean that one has diversified one's portfolio. In the example of our hill station, both the businesses have exactly opposite effect of the changing weather. Similarly, when one is investing in various businesses either through profession, or through stocks or through growth mutual funds, one needs to be careful in ensuring that the underlying businesses do not have the same impact of various changes that happen in the environment.

Assume an investor invests in bank fixed deposits as well as equity mutual funds. An equity mutual fund portfolio may have stocks from various industries, e.g., Petrochemicals, FMCG, Pharmaceuticals, Automobiles, Information Technology, Banking, etc. When the governor of Reserve Bank of India makes some policy announcement, the same may have an impact (either positive or negative) on stocks of banks, but may not have any impact on the stocks of IT or Pharma companies. Similarly, when the exchange rate between the Indian Rupee and the US Dollar fluctuate, it may have an impact on the export oriented companies (These companies export their goods or services and earn in foreign currency) and an exactly opposite impact on the companies dependent on imported raw materials (These import goods or services and thus spend foreign currency). Thus, the equity investments are considered to be properly diversified. However, when the overall preference of investors shifts towards or against the stock markets, the stock prices of almost all the companies across the stock market fluctuate together, in spite of having different businesses. The fluctuations in the stock market prices cause the NAVs of the mutual funds to fluctuate, but the same has no impact on the value or the interest on the fixed deposits. Thus, we can safely say that the investor has invested in two unrelated asset classes - a very important thing to keep in mind while building a diversified portfolio.

As can be understood from the above discussion, the fluctuation in the values of individual components is unchanged, but the changes in the value of the portfolio of the investor are moderated. At the same time, the returns from the portfolio would be a weighted average of the returns from the individual components. Thus, through diversification, the returns got averaged but the risk got cancelled partially.

Having understood the benefits of diversification, how can investors put it into practice? An investor can simply look at various investment options and find out if they are relatively less related and then buy those options. At times, one may require large sums of money to properly diversify. Mutual funds offer the benefit of diversification even for small investments. A mutual fund is constructed in form of a corpus collected from many small sized investors. Collectively all the small investments merge into a large portfolio giving it the economies of scale. Thus, the portfolio is in a position to achieve the diversification objective.

The author Mr. Amit Trivedi runs Karmayog Knowledge Academy. The views expressed are his personal opinions. He can be reached at karmayog.knowledge@gmail.com