Author: Manjunath Gaddi
You hear it so often. Most financial advisers will encourage investors to diversify their investment portfolios. In actual fact, does diversification really work?
Diversification involves splitting up your money so that it can be invested in different kinds of investments. Put simply, it means not putting all your eggs in one basket. But some investors may argue that if all their money was to be placed into one `good` investment, they would achieve the `maximum` amount of returns. But that is only with the benefit of hindsight. In reality, it is difficult to predict the investments which will deliver the `best` profits in the future.
Wider exposure at lower risk levels
The uncertainty in the investment world may have led some investors to place all their monies into safer investments such as fixed deposits. Others may adopt another extreme way of investing by putting all their monies into just one high-risk investment. Both methods are not advisable. The latter is akin to betting, while the former means forgoing good investment opportunities. The benefit of diversification is that it gives investors a wider exposure to various investments at a lower risk level.
We set out a simple hypothetical example below:
In this instance, there are 5 possible investments, labeled A, B, C, D and E. At this juncture, each of these investments seems like it can deliver good returns. For investors who choose to avoid investing in all 5 investments, but put their monies into fixed deposits instead, they could be forgoing several potentially good investment opportunities. For investors who decide to put all their money into just one of these investments, their chances of making it big is around 1 in 5 mathematically, or just 20%.
Let`s see what happens to the portfolio if we diversify it by splitting our monies into 5 equal portions and invest them in the 5 investments, namely A, B, C, D and E.
You hear it so often. Most financial advisers will encourage investors to diversify their investment portfolios. In actual fact, does diversification really work?
Diversification involves splitting up your money so that it can be invested in different kinds of investments. Put simply, it means not putting all your eggs in one basket. But some investors may argue that if all their money was to be placed into one `good` investment, they would achieve the `maximum` amount of returns. But that is only with the benefit of hindsight. In reality, it is difficult to predict the investments which will deliver the `best` profits in the future.
Wider exposure at lower risk levels
The uncertainty in the investment world may have led some investors to place all their monies into safer investments such as fixed deposits. Others may adopt another extreme way of investing by putting all their monies into just one high-risk investment. Both methods are not advisable. The latter is akin to betting, while the former means forgoing good investment opportunities. The benefit of diversification is that it gives investors a wider exposure to various investments at a lower risk level.
We set out a simple hypothetical example below:
In this instance, there are 5 possible investments, labeled A, B, C, D and E. At this juncture, each of these investments seems like it can deliver good returns. For investors who choose to avoid investing in all 5 investments, but put their monies into fixed deposits instead, they could be forgoing several potentially good investment opportunities. For investors who decide to put all their money into just one of these investments, their chances of making it big is around 1 in 5 mathematically, or just 20%.
Let`s see what happens to the portfolio if we diversify it by splitting our monies into 5 equal portions and invest them in the 5 investments, namely A, B, C, D and E.
Table 1: Investment allocation | |||||
Investment | A | B | C | D | E |
Amount Invested | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 |
Let`s now assume that these investments are left untouched for 20 years and the investments had reaped the following annualized returns:
Table 2: Assumption for annualised returns | |||||
Investment | A | B | C | D | E |
Annualised Return | +15% | +5% | 0% | -5% | -15% |
After the 20-year holding period, how many of you are thinking that the diversification exercise was a total waste of time because you are back at where you started with the original Rs 25,000?
In reality, you might be surprised to find that the actual amount of your total investment holdings, including profit, after 20 years, based on the above returns, is Rs 102,085! This is four times higher than the original investment amount.
The power of diversification
The portfolio has now effectively delivered an annualized return of 7.3% on average each year. How could the portfolio deliver such good returns when it appeared the portfolio should have made no gains at all?
In reality, you might be surprised to find that the actual amount of your total investment holdings, including profit, after 20 years, based on the above returns, is Rs 102,085! This is four times higher than the original investment amount.
The power of diversification
The portfolio has now effectively delivered an annualized return of 7.3% on average each year. How could the portfolio deliver such good returns when it appeared the portfolio should have made no gains at all?
Let`s consider the following illustration:
Table 3: Value of Investment After 20 Years | ||||||
Year | Fund A | Fund B | Fund C | Fund D | Fund E | Total |
0 | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 | Rs. 5,000 | Rs. 25,000 |
1 | Rs. 5,750 | Rs. 5,250 | Rs. 5,000 | Rs. 4,750 | Rs. 4,250 | Rs. 25,000 |
2 | Rs. 6,613 | Rs. 5,513 | Rs. 5,000 | Rs. 4,513 | Rs. 3,613 | Rs. 25,250 |
3 | Rs. 7,604 | Rs. 5,788 | Rs. 5,000 | Rs. 4,287 | Rs. 3,071 | Rs. 25,750 |
4 | Rs. 8,745 | Rs. 6,078 | Rs. 5,000 | Rs. 4,073 | Rs. 2,610 | Rs. 26,505 |
5 | Rs. 10,057 | Rs. 6,381 | Rs. 5,000 | Rs. 3,869 | Rs. 2,219 | Rs. 27,526 |
6 | Rs. 11,565 | Rs. 6,700 | Rs. 5,000 | Rs. 3,675 | Rs. 1,886 | Rs. 28,827 |
7 | Rs. 13,300 | Rs. 7,036 | Rs. 5,000 | Rs. 3,492 | Rs. 1,603 | Rs. 30,430 |
8 | Rs. 15,295 | Rs. 7,387 | Rs. 5,000 | Rs. 3,317 | Rs. 1,362 | Rs. 32,362 |
9 | Rs. 17,589 | Rs. 7,757 | Rs. 5,000 | Rs. 3,151 | Rs. 1,158 | Rs. 34,655 |
10 | Rs. 20,228 | Rs. 8,144 | Rs. 5,000 | Rs. 2,994 | Rs. 984 | Rs. 37,350 |
11 | Rs. 23,262 | Rs. 8,522 | Rs. 5,000 | Rs. 2,844 | Rs. 837 | Rs. 40,494 |
12 | Rs. 26,751 | Rs. 8,979 | Rs. 5,000 | Rs. 2,702 | Rs. 711 | Rs. 44,144 |
13 | Rs. 30,764 | Rs. 9,428 | Rs. 5,000 | Rs. 2,567 | Rs. 605 | Rs. 48,363 |
14 | Rs. 35,379 | Rs. 9,900 | Rs. 5,000 | Rs. 2,438 | Rs. 514 | Rs. 53,230 |
15 | Rs. 40,685 | Rs. 10,395 | Rs. 5,000 | Rs. 2,316 | Rs. 437 | Rs. 58,833 |
16 | Rs. 46,788 | Rs. 10,914 | Rs. 5,000 | Rs. 2,201 | Rs. 371 | Rs. 65,274 |
17 | Rs. 53,806 | Rs. 11,460 | Rs. 5,000 | Rs. 2,091 | Rs. 316 | Rs. 72,673 |
18 | Rs. 61,877 | Rs. 12,033 | Rs. 5,000 | Rs. 1,986 | Rs. 268 | Rs. 81,165 |
19 | Rs. 71,159 | Rs. 12,635 | Rs. 5,000 | Rs. 1,887 | Rs. 228 | Rs. 90,908 |
20 | Rs. 81,833 | Rs. 13,266 | Rs. 5,000 | Rs. 1,792 | Rs. 194 | Rs. 1,02,085 |
Annualised Returns | +15% | +5% | 0% | -5% | -15% | +7.3% |
Source: Fundsupermart.com Compilations | ||||||
In the first year, we see that the portfolio delivered exactly zero returns. However, as the years passed, the worst performing investment formed a smaller part of the total portfolio, while the best performing investment became a bigger part of the portfolio. Eventually, the compounded returns of investment A, (and to a lesser extent, investment B) helped the portfolio to deliver good overall returns.
This highlights both the power of compounding as well as that of diversification. On seeing the individual returns, some might think that the investments chosen for the above example were terrible. Two out of the five investments lost money consistently, and investment C can be likened to placing your money into a drawer! Even investment B was not that impressive, as it only returned 5% per year - nothing to be exceptionally excited about! However, the power of diversification has allowed the portfolio to reap an annualized portfolio return of 7.3%.
Thus, when you diversify your portfolio, not all your investments have to make it big; you may just need some of them to succeed.
Fund Managers` Widely Employed Strategy
Diversification is what fund managers usually attempt to do with their stock selection, and this is also the reason we advise investors to diversify their investments. In the examples we have examined, diversification could ensure that we would get a good return for our portfolio, even if two of the selected investments performed badly, and one was the equivalent of stashing your money away under the mattress!
In reality, it is also unlikely that an investor will end up with an investment that consistently loses money in every single year for 20 years. He would most likely have switched out from this investment long before the period of 20 years was up! At the same time, it is also not easy to have an investment that delivers annualized returns of 15% over 20 years.
Nevertheless, the above illustration was meant to highlight to the investors the concept of diversification and to show why it works statistically. Through the examples, we hope investors will realize why the concept of diversification is extremely important. This principle allows you to invest with greater confidence, as not all your investments will need to be huge winners in order to obtain good overall returns for your portfolio.
This highlights both the power of compounding as well as that of diversification. On seeing the individual returns, some might think that the investments chosen for the above example were terrible. Two out of the five investments lost money consistently, and investment C can be likened to placing your money into a drawer! Even investment B was not that impressive, as it only returned 5% per year - nothing to be exceptionally excited about! However, the power of diversification has allowed the portfolio to reap an annualized portfolio return of 7.3%.
Thus, when you diversify your portfolio, not all your investments have to make it big; you may just need some of them to succeed.
Fund Managers` Widely Employed Strategy
Diversification is what fund managers usually attempt to do with their stock selection, and this is also the reason we advise investors to diversify their investments. In the examples we have examined, diversification could ensure that we would get a good return for our portfolio, even if two of the selected investments performed badly, and one was the equivalent of stashing your money away under the mattress!
In reality, it is also unlikely that an investor will end up with an investment that consistently loses money in every single year for 20 years. He would most likely have switched out from this investment long before the period of 20 years was up! At the same time, it is also not easy to have an investment that delivers annualized returns of 15% over 20 years.
Nevertheless, the above illustration was meant to highlight to the investors the concept of diversification and to show why it works statistically. Through the examples, we hope investors will realize why the concept of diversification is extremely important. This principle allows you to invest with greater confidence, as not all your investments will need to be huge winners in order to obtain good overall returns for your portfolio.
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