The risk of not diversifying

Sharad Gandhi came to me with his entire investment portfolio. He wanted to know if his investments were well-balanced and diversified. When I told him I couldn’t see any kind of diversification, he thought I was joking at first. However, he soon realised that I was serious about it.

His investments included direct equity, equity mutual funds and also a portfolio management scheme investing in equity markets. His entire portfolio was in equity.

I faced a similar experience many years ago, when an elderly gentleman came to me with investments in bank FDs, company FDs, National Saving Certificates, debt mutual funds and Government of India bonds. All his investments were only in debt instruments.

This is a very common phenomenon. Most investors diversify across investment vehicles and not across asset classes.

Types of asset classes

There are mainly four kinds of asset classes — equity, gold, real estate and debt. Let us very briefly discuss the characteristics.

When we invest in equity, we become the owner of the company. We share the ownership. An owner of the company may make profit or lose money. However, in the long run, business will not survive if it continuously makes losses. Therefore, investment in equity is volatile in giving returns, but over a longer period, substantial returns are possible.

Gold is a metal that can be used for self-consumption or investment. It is a physical asset which we can see and touch. Nowadays, there are options to invest in gold in the form of mutual funds, bonds, etc. Returns from gold, like equity, can move in either direction. While investing in gold, it is important to keep in mind whether it is for self-consumption, investment, or of religious signifance in the Indian context. Investment in gold is highly liquid — it can be easily encashed. Real estate, like gold, may be for self-consumption or investment. It is important to distinguish between the two. An adverse characteristic of real estate is that it is illiquid, indivisible and immovable – we cannot sell real estate easily. To boot, it is immovable. Both in the case of gold and real estate, do not consider the one that is acquired for self-consumption as an investment. We tend to develop attachment with items meant for self consumption and hence undergo mental struggle if we need to sell them at a later date.

Finally, there is debt as an asset class. Debt is borrowing. We can borrow money to fund our requirements. On the other hand, we can lend to an individual or institution. When we lend money, we are creating an asset in the form of debt. Returns from debt instruments are in the form of interest.

Investment vehicles

To invest into these four different asset classes, there are various investment vehicles such as mutual funds, portfolio management services, and direct investments.

It is important to diversify across asset classes to reduce the overall risk in one’s portfolio.

Someone rightly said, “If a part of your portfolio is not giving negative returns, then you are not diversified enough.”

Mistakes we make

A common mistake observed in investors is their liking for real estate. I recall an elderly lady visiting my office in 2014. Her late husband had left her a total portfolio of ₹8.25 crore, apart from the house in which she was living. Of the total portfolio, there was a flat in Worli, Mumbai, which was worth approximately ₹7.50 crore.

The other investments included bank FDs, a PPF account, equity mutual funds, and a few direct equity shares. She was struggling a little to secure a regular income. Also, as a planner, my concern was what would she do if there was a prolonged illness? This is another example of a non-diversified portfolio.

Non-diversification is a big risk which most investors unknowingly ignore. This is because of their liking for a particular type of asset such as equity, gold, real estate or debt. What probably induces this behaviour is that in the past, a particular asset class would have probably given them very high returns and hence the affinity towards that asset class. Another reason could be a bad experience with a particular kind of investment (equity in all likelihood).

Due to a not-so-good experience, they might refrain from investing in that asset class. No investment is evergreen. As they say, “winners rotate.”

Therefore, to ensure that we have a well-balanced, diversified portfolio, we must invest across different asset classes. Diversification is recommended across asset classes and not necessarily investment vehicles.

One should remember that real life long-term returns is not what a portfolio does, it is what the investor does.

(The writer is a financial planner & author of Yogic Wealth)

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Printable version | Sep 8, 2022 5:42:33 pm |