Portfolio Diversification – If you ignore then it COSTS YOU

Many of you might have heard from me or from few experts referring to portfolio diversification or asset allocation. But the majority of investors ignore this first and basic important step of investment.

In my earlier posts (Financial Goals – How to set before jumping into investing? and Top 10 Best SIP Mutual Funds to invest in India in 2018), I stressed about the basics one has to prepare before jumping into selecting a product or assets. However, many of the readers still not able to understand the importance of Portfolio Diversification.

Hence, in this post, with simple logic let me explain how the portfolio diversification will actually save your invested money. REMEMBER THAT IT WILL NOT ENHANCE YOUR RETURN BUT DEFINITELY A BEST WAY TO MANAGE THE RISKS.

What will happen when we forget portfolio diversification?

Assume that you have to invest Rs.1,000. Let us also assume that you are investing the all this Rs.1,000 into a single asset. Now if you start tossing the coin. If you find the coin HEADS up, then assume your investment will go up by 30%. If you find the coin TAILS up, then assume your investment will go down by 10%.

Therefore whenever you toss the coin and find the HEDS up, then your Rs.1,000 will go up by Rs.1,300. Same way if you toss the coin and find the TAILS up, then your Rs.1,000 will go down to Rs.900.

Now, if you toss the coin, then there are two possibilities to it. Either HEADS up or TAILS up means 50% changes at either way.

HEADS up=30% Profit and your invested money will be Rs.1,300

TAILS up=10% Loss and your invested money will be Rs.900.

Portfolio Diversification – A simple logic to understand the importance

Now instead of investing all Rs.1,000 into a single asset, let us divide this Rs.1,000 into two assets (call it as buckets). One bucket with Rs.500 and another bucket with Rs.500. Also, instead of one coin now we add one more coin as we now split our investment into TWO.

Therefore, now we have two coins and our investments are split into two assets or products. If you toss both the coins, then what will be the probability??

Let me explain the same as below.

Once you toss the two coins, then you will find two probabilities to occur. They are as below.

# TWO HEADS

We may find that two coins may be resulting in two heads up. In such scenario, heads up means 30% returns to both Rs.500 buckets. Hence, Rs.500 (first bucket)+Rs.150 (30% profit on Rs.500)+Rs.500 (second bucket)+Rs.150 (30% profit on Rs.500)=Rs.1,300.

Therefore, if such scenario occurs then we end up with Rs.300 profit in our portfolio.

# TWO TAILS

We may find that two coins may be resulting in two tails up. In such scenario, tails up mean 10% loss to both Rs.500 buckets. Hence, Rs.500 (first bucket)-Rs.50 (10% loss on Rs.500)+Rs.500 (second bucket)-Rs.50 (10% loss on Rs.500)=Rs.900.

Therefore, if such scenario occurs then we end up with Rs.100 loss in our portfolio.

# A HEAD AND A TAIL

Suppose we get one coin head up and another coin tail up, then what will happen? In such scenario, head means 30% profit and tail mean 10% loss. Hence, Rs.500 (first bucket)+Rs.150 (30% profit on Rs.500)+Rs.500 (second bucket)-Rs.50 (10% loss on Rs.500)=Rs.1,100.

Even though in this case we faced a loss of 10% due to TAIL up, we still ended up with the profit of Rs.100.

# A TAIL AND A HEAD

Suppose we get one coin tail up and another coin head up, then what will happen? In such scenario, head means 30% profit and tail mean 10% loss. Hence, Rs.500 (first bucket)-Rs.50 (10% loss on Rs.500)+Rs.500 (second bucket)-Rs.150 (30% profit on Rs.500)=Rs.1,100.

Even though in this case we faced a loss of 10% due to TAIL up, we still ended up with the profit of Rs.100.

Let me explain the same in below image of Rs.1,000 invested in a single asset or when we diversify into two assets then what will be the result.

Portfolio Diversification - A simple logic to udnerstand the importance

You notice that when you do not diversify your investment then there is a 50% chances of profit and same way loss also. However, when you diversify your investment into two asset classes, then such chances of loss reduced to 25%. In remaining three probabilities of a diversified portfolio, even though there is a probability of loss, we still end up with profit than what we invested.

Hence, if you not diversify, then the probability of loss is higher. However, when you diversify your investment, then the probability of loss will get reduced.

I am repeating once again of what I said at the start. REMEMBER THAT IT WILL NOT ENHANCE YOUR RETURN BUT DEFINITELY A BEST WAY TO MANAGE THE RISKS.

INVESTMENT IS NOTHING BUT HOW WELL YOU MANAGE THE RISK RATHER THAN CHASING THE RETURNS.

Hope this simple explanation will make you aware of the importance of diversification for your investment.

13 Comments

  1. Can I have article about the index funds ?
    Is it good to invest in Index funds or not?

    Reply
    • Dear Chandu,
      Let me write the one soon. Good or bad depends on what type of Index you are investing and your purpose.

      Reply
  2. Hello Basavaraj ji, I found your blog while searching for financial information. So nice, so good. Full of micro details.

    I have dsp black rock top 100 mutual fund and putting money from seven years (2011). I am investing 10,000 every month. I also bought SBI blue chip fund two years back with 10,000 every month. I invest 5,000/month in RD.

    I am 40 now and need 50 lakh at the age of 50 for building a house. Do you think these funds are good enough and shall I hold them. I know you cannot predict fund performance but need your advice. Also, can I complete my goal of 50 lakh with it? Thank you for the in advance.

    Reply
    • Dear Rao,
      If we consider your time horizon as 10 years, then I suggest you to follow 60:40 in debt and equity. In equity, hold one large cap like SBI Bluechip and also one mid cap fund like HDFC Midcap Opp Fund. In debt, instead of RD, I suggest you to use either Liquid Fund or Ultra Short Term Debt Fund.

      Reply
  3. Dear Mr. Basavraj,
    Thank you for such an important discussion.

    Reply
  4. Wonderful sir. I really liked the way you explained it. Thanks for your guidance.

    Reply
  5. Really good knowledgeable article Basu sir. Nice explanation with example. Basu sir i have one question (not sure whether i am correct) in this regard i understand we need to diversify the investments. Some where i remember reading too much diversification is also not good. So to what extent diversification is good do we have any formula or logic for the same ? sharing move information on this will be helpful for all of us.

    Reply
    • Dear Sat,
      Yes, too much diversification is also a BAD. There is no such standard rule that how much % of diversification is considered as too much diversification. Hence, it is always best to check overlap also before diversifying.

      Reply
      • Hi Basu sir thanks for the guidance and highly appreciated

        Reply
  6. Dear Basu

    Knowledgeable article. Further, I really appreciate you giving me a clean slate by removing all those disturbing ads from your site and now the page has a spotless look, as clear as crystal.

    Thanks.

    RK Bhuwalka

    Reply
    • Dear Bhuwalka,
      Thanks for your appreciation. Regarding ads, I am not sure what changed at your END. Because I have not done any changes. All of those ads are still active.

      Reply

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