Diversification is considered to be a complex topic amongst stock market beginners. However, after removing all the jargon of the financial world, it becomes a very simple concept which should be applied by all investors for building their portfolio. Before going into the steps which stock market beginners can apply to diversify their portfolio, let’s understand the concept of diversification.
What is diversification?
Diversification is the allocation of capital into multiple assets which help an investor to reduce risk and remove extreme volatility from his/her portfolio. Simply put, it is an effort made by an investor to reduce his/her risk by increasing the number of bets in the stock market. It is an essential tool of a stock market investor’s toolkit which can prevent massive losses.
Let’s understand diversification with a simple example. Imagine that there are two investors – Ram & Shyam. Both have invested Rs. 10 Lakh in the stock market. However, both the investors follow a very different approach. Ram has invested all of his money in only 2 stocks (Rs. 5 lakhs each) whereas Shyam has diversified his portfolio by investing in 25 different stocks using a capital of Rs. 40,000 each. The final results which Ram & Shyam will obtain after years of investment can be wildly different. Whose portfolio do you think is safer?
The answer is obviously Shyam’s portfolio. Ram can have extreme volatility on his portfolio due to lack of different bets. If the 2 stocks chosen by Ram become the hottest companies in the town, he could easily become a crorepati. However, if any one of his companies go bankrupt, he will lose most of his capital! Shyam, on the other hand, has a much higher probability of making decent returns on his portfolio without major volatility. The reason is simply because Shyam is much less affected by any of his companies going bankrupt. Also, he will make much less money if any of his companies become the best companies in India.
Ram’s chances of success highly depend on his stock picking skills & luck whereas Shyam’s chances of success are not dependent on him being a stock market genius!
Why does diversification have a bad reputation?
Diversification sometimes has a bad reputation amongst seasoned investors. Many reputed investors are against the idea of diversification, going as far as saying “Diversification is for Idiots” (by American investor Mark Cuban). Even the famous investor Warren Buffet is against the idea of diversification, calling it “Diversification is protection against ignorance” and “It makes little sense if you know what you are doing”. So, is diversification important? Or is it only for new investors who don’t know what they are doing?
For this, we need to understand the two kinds of diversifications which are typically used by stock market beginners. The two kinds of diversification are – bad diversification & good diversification.
Bad diversification is when an investor buys every single stock which is available in the stock market due to his/her lack of knowledge about the stock market. Such a portfolio cannot provide any meaningful return to the investor since the portfolio is too spread out! Simply buying every single stock in the name of diversification is not a smart strategy.
Good diversification is when an investor uses diversification to reduce his/her risk in the stock market while placing bets on specific sectors in the stock market. All the stocks are chosen by proper research & not simply to make the portfolio diversified. The diversification part is only done to protect the investor from unforeseen issues!
Steps to diversify your portfolio
Here is a simple list of steps which investors can follow to diversify their portfolio.
Step 1 : Identify strong sectors in the stock market
The most important step for a stock market beginner is to identify the strongest sector in the stock market. Most sectors in the stock market follow a cyclical approach i.e. they will have an up-cycle (where the stocks perform very well) & a down-cycle (i.e. when the stock performs poorly). To learn more about the cyclical nature of the stock market, visit this article!
Smart investors try to identify the best sectors which have a bright future for the next few years. A simple approach to identify such sectors – find sectors which have new innovations, more demand in the future &/or emerging sectors which have a massive growth potential. On the other hand, a sector which may not do well can be a sector where the industry is old-fashioned &/or which are being replaced by other technologies. An example of a sector which has a potential to grow in the future in India could be the credit card industry. An example of a sector which might not grow much in India could be the coal industry. To learn more, visit – How to choose your first Stock?
Once the best sectors which have a bright future ahead of them have been identified, this takes us to the next step.
Step 2 : Identify the market leaders within the strongest sectors
After the identification of the strongest sectors in the stock market, our job as an investor is to find out the market leaders within the strongest sectors. Some of the key characteristics of market leaders include –
- Higher market share than its peers
- Higher market capitalization than its peers
- Higher growth than its peers
- More interest of big funds (higher DII/FII shareholding)
Many such companies are common household names which have been around for decades. Such companies have created huge brands which have been bringing big profits to the companies. A simple method to identify some of the market leaders is to check out the companies which are part of the Nifty 50 index! (which consists of some of the biggest companies in India)
Always identify the top 4-5 best companies in the sectors, not just the single best company in your preferred sector. Once the market leaders are identified, we move onto our next step.
Step 3 : Divide your capital into the market leaders
Dividing your capital into the market leaders can be performed in various ways. One simple method is to divide the capital equally into the 4-5 stocks which you have identified for your sector. Another method could be to divide your capital by giving more preference to larger companies than smaller companies. There is no right or wrong method to divide your capital amongst your chosen picks.
However, one thing which you should ensure is that the capital for each stock is relatively similar. If you are dividing your capital into 5 stocks as 80%, 5%, 5%, 5%, 5%, then you’re not really diversifying your portfolio properly due to the high risk on a single stock. A capital division of 30%, 20%, 20%, 15%, 15% into 5 companies can be a good way to divide your capital into different stocks. The idea here is to keep all the gems within the sector in your portfolio. We never know which stock will perform the best of them all! To learn more, visit – Can anyone predict the stock market?
NOTE : Avoid more than 10% exposure in a single stock
An important note to keep in mind is to avoid an exposure of more than 10% of your total investment capital into a single stock. If you have a portfolio of Rs. 10 Lakh, then none of your stocks should have an investment of over Rs. 1 Lakh. A very high exposure on a single stock can cause your portfolio to have high volatility & have dangers similar to an undiversified portfolio!
But I know which company is the best! Why should I diversify?
Many investors are still against diversification because they only want to invest their capital into the top stocks. If you know the best company in a particular sector, shouldn’t you invest all of your money in the best company possible?
The answer is – NO, you should always diversify your portfolio. Nobody knows which company will perform the best in the future & anybody who claims the same is simply lucky or lying. There have been countless examples of companies which were at one point of time the best companies in their sector but they ended up being the biggest wealth destroyers for their investors. Such examples are present in every sector of the stock market.
Some examples of the market leaders going out of business include –
- Yes Bank – It was one of the fastest growing banks in India.
- Kodak – It had the largest market share for cameras in India.
- Nokia – It had the largest market share for mobile phones within India.
- Satyam – It was one of the fastest growing IT companies in India.
- India Bulls Housing Finance – It was one of the biggest real estate company in India.
- Yahoo – It was one of the biggest tech companies in the US & was planning on buying google. Article link here!
The common thing amongst all of these past market leaders is that they had their downfall & were defeated by their competitors who became new market leaders. Imagine being an investor who only had stocks of Yes bank & did not diversify his/her portfolio by including other banks. Or having only Nokia shares & no shares of other mobile phone companies. Investing in only the market leader is full of risk because we never know which company might become the new market leader!
This is exactly why you should never hold a good stock forever. To learn more, visit this article – Should I hold a Good Stock forever?
Conclusion
Diversification is an essential tool for every stock market investor which can prevent him/her from massive losses in the market. Having a well diversified portfolio can reduce the risk for an investor & provide a stable return from the stock market. However, the final decision of investing depends entirely upon the reader!
If you liked this article, share & subscribe to this website! Follow us on Twitter for quick notification!
DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
- 4 Types of Stocks which Long-Term Investors should avoid! - May 6, 2023
- Why do some companies trade at a very low P/E multiple? - November 1, 2022
- Why most investors end up buying stocks at the wrong time? - October 26, 2022
