Diversification is the allocation of capital into multiple assets which help an investor to reduce risk and remove extreme volatility from his/her portfolio. It is an important tool in risk management which should be followed by both investors and traders for their stock market journey. In an ever changing world, a lack of diversification can cause a massive blow to the financial health of an investor.
However, diversification has a bad reputation. Many reputed investors are against the idea of diversification, going as far as saying “Diversification is for Idiots” (said by the 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?
Diversification is extremely important for newbie investors as well as seasoned investors. It is an essential tool to protect the investor against the constantly changing world in which we live. No investor, regardless of their years of experience can predict the future. Every decision made by any investor is based on the current situation and the expected future projections for the company. However, the actual investment journey is always filled with surprises! To learn more, visit this article – Can anyone predict the stock market?
Here are the reasons why lack of diversification can destroy your wealth.
1. Even big companies fail!
Many investors who invest only in the biggest companies (large cap companies) consider their investment to be fool-proof. However, history has shown us that not even the biggest companies in the world are immune to failure. There have been many examples of companies which fell from grace due to some (or many) mistakes which they made leading to their eventual failure.
A great example is a company called Kodak. Remember the 90s when every family in India had a Kodak camera! Kodak cameras were a big hit at that time & had the lion’s share in terms of camera sales and film sales (also known as camera reels).
This company failed to adapt with the changing world and stuck to the old ways of cameras which required image printing when the entire world was moving towards digital cameras. The world moved to a new technology leaving Kodak behind which caused the company to file for bankruptcy in 2012.
Another example is the famous auto manufacturer General Motors. After being one of the biggest car manufacturers for around 100 years, General Motors was forced to file for bankruptcy in 2009 following the stock market crash caused by the mortgage crisis in the USA in 2008.
It is clear that no company (not even the biggest in the world) is immune to the changing world. Every company has a non-zero probability to fail, even the ones which have had a phenomenal track record in the past. Imagine being the investor who had both Kodak & General Motors in his/her portfolio. Such an investor would have been financially slaughtered without proper diversification even though the decision to invest in either of these companies was a great decision during their heyday. This is the reason why holding a stock forever can be a bad strategy. To learn more – visit this article!
2. Negative sentiments about a sector
Many investors have a favourite sector in which they love to invest. The sector could be your favourite because of multiple reasons – maybe you are working in that sector as a professional or maybe you spend a lot of time learning about the sector due to your own interest or maybe that sector is the shining star of the future. Whatever may be the reason, being heavily invested in a single sector is a big risk which a smart investor should avoid.
Let’s suppose you love to invest only in the banking sector. The mortgage crisis in the USA which led to the stock market crash in 2008 spread negative sentiment about the banking sector around the world. Everyone was selling banking stocks in a ruthless manner leading to major losses to the investors who were heavily invested in the banking sector.
Stock market works in a cycle where sectors constantly go in and out of favour. Diversifying your investment amongst multiple sectors is a great way for investors to avoid major losses if their favourite sector goes out of favour. To learn more about this, visit this article – What is sector rotation in the stock market?
3. Major world events
There is a possibility of a major world event which can happen at any time which is outside the control of an investor. The recent example is the coronavirus pandemic which caused major economic losses due by shutdowns in various countries in the world. The impact of the coronavirus pandemic was positive for some companies which belonged to the IT & pharma sectors. However, there were some sectors such as hotels, manufacturing, tourism, etc. which suffered heavy losses. Such events can happen at any time in the blink of an eye which can cause major losses to specific companies. A well diversified portfolio protects the investor from getting wiped out in case of such events!
A change in government, war between two countries, death of a country (or a company) leader, terrorist attacks, etc. are things which can happen in any part of the world at any time. Only an investor who is well diversified to protect himself/herself from any such world events will be able to create long term wealth in the stock market. You can’t create wealth in the stock market, if you lose all your capital due to any world event!
4. Change in government policy
Government policy remains a big factor in the performance of the stock market of the country. There are many instances in which a government policy directly impacts the earnings of a company. A classic example of such a company is ITC which is the largest producer and seller of cigarettes in the country.
The performance of ITC has been going downhill due to the huge pressure which the company has to face every time the taxes on cigarettes are increased. The increase in taxes has a direct impact on the cost of the product which the company has to offer, which is unfavourable for the company. The effect of such a policy can be seen in the stock price of ITC which has been in a down-trend since 2017.
Any change in the government policies is unpredictable for an investor (especially retail investors). This is another major reason why having a well-diversified portfolio can protect investors from such sudden surprises by changing policies.
5. Scams
Scams are common in the world of investment. Almost every month, there are companies around the world which make the news by coming up with a new scheme to scam investors out of their money. Scams are almost impossible to predict before they actually happen & by the time the information of a scam becomes public, the stock would have already plunged.
According to the website scamwatch, out of all the scams in the world, the majority of the money loss occurs in investment related scams.
There have been many examples of scams in India which led to the erosion investor’s wealth. The recent example of a scam is Yes Bank which saw the stock falling from its heights of around Rs. 380 in the year 2018 to a price of around Rs. 10 in the year 2022. Such scams are an unavoidable part of an investor’s life. Diversification can prove to be a great way to protect investors against such scams.
How can I diversify my portfolio?
A well-diversified portfolio contains around 20-25 companies which span across different industrial sectors. There is no set rule of the number of companies which the investor should have, however having a minimum 20-25 companies is sufficient to protect the investor from the unpredictability of the future.
Is there something called bad diversification?
Diversification protects investors against major losses. But is there a thing called bad diversification? Yes, there is a bad diversification! Some investors misunderstand the concept of diversification & start accumulating stock of every company which is listed in BSE. This is the wrong way of diversification. The idea of diversification is to distribute your capital amongst the companies which are best suited for future growth. This doesn’t mean that any company (regardless of its fundamentals) should be bought in the name of diversification. Remember, there are around 7000 companies listed in BSE. A well-diversified portfolio contains around 20-25 companies which means there is a lot of work to be done by the investor in terms of stock selection. To learn more about stock selection, visit this article – How to choose your first stock?
If you are completely new investor who has no idea on how to invest in the stock market and are looking for an option of passive investment, then the Index funds are the best options for you! To learn more about index funds, visit this article!
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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
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