Let’s start off with a story.
Ramu is a street hawker who buys items that he can sell after adding a margin. He may choose from two items in wholesale, sunglasses and umbrellas, for the sake of simplicity. If he chooses to sell Umbrellas and the day is sunny, his business wouldn’t do well. However, he would sell out all his stock if it rains instead. Similarly, if he selected sunglasses to sell, he would sell all his stock on a sunny day but close to none on a cloudy day. If instead, Ramu chooses to sell both umbrellas and sunglasses, he can be relatively confident of steady business regardless of whether the day is sunny or cloudy. While it is not likely that he will sell out his stock on any given day, he will also not likely go home empty-handed. A steady such flow of business would be preferable over a roller-coaster of stock-outs on one day and no business the next.
This is diversification, a key concept in finance. A common-sense strategy that one should not put all their eggs in one basket. Typically, our finances tend to be concentrated, unless we take active steps to diversify it.
A few typical examples of concentration are as follows:
- Your monthly salary makes up almost your entire income
- Your entire net worth is in your home country (E.g., India)
- Almost your entire net worth is in real estate, concentrating your net worth to a single locality
- Almost all your liquid investments are in shares
- Most of your investments are in a handful of companies
Each concentration is, in fact, a bet that you are taking on. There’s always the possibility that the asset you have bet on grows faster than inflation, and you reap great rewards. However, if the asset underperforms inflation, you stare at a possibility of a much smaller nest egg at the end of your accumulation journey and may face a consequent erosion of your quality of life. It should also be noted that diversification is good when in moderation. There is no benefit of owning thirty Mutual Funds if they are mostly invested in the same underlying companies. There is no benefit of selecting and owning forty shares across the same four industries. For each of the examples above, there are simple actions that can be taken to reduce concentration and enhance diversification:
- Grow additional streams of active or passive income
- Invest outside your home country through direct stocks or mutual funds
- Limit investments in illiquid real estate assets
- Increase the liquid asset classes invested in beyond equity through Bonds and REITs
- Diversify the number, size and sectors of shares you have invested in through mutual funds
We will delve into each aspect of the above in the fullness of time. There is still systemic risk that cannot be diversified away, but that’s a story for another day. For now, here’s some additional reading on diversification.