Lesson 12 – Diversification

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Lesson 12 – Portfolio diversification

Portfolio diversification is an important part of stock investing. This lesson covers the need for diversification, the degree of diversification that you need and rebalancing.

What is the need for diversification?

The old adage, “Don’t keep all your eggs in one basket”, explains the logic of diversification.

Stock gains are not guaranteed. There can be stock price falls for various reasons. A few are listed below:

  • Individual stock overvaluation which corrects over time
  • General stock market falls which bring down all stocks, irrespective of whether they are undervalued and overvalued
  • Market reaction to a company’s bad results or adverse business developments
  • Sale of pledged shares.

The pledged shares concept needs explanation. A promoter may have pledged their shares with a lender and borrowed money. The lender keeps the promoter shares as security. Usually the value of promoter shares is at least double of the amount lent to promoter. If there is a stock price drop and the lender feels that the promoter shares do not constitute adequate security, they issue margin calls asking the promoter to make good the difference. If promoter is unable to pay up, the lender can sell all the shares in the market causing huge sell orders which drive the price down usually to lower circuit filters.

In general, when you invest in a stock where promoter has pledged shares there is high risk if the amount of pledged shares is a big percentage of the company’s outstanding shares.

Let me give you an interesting example of an adverse development.

A company called Genus Power Infrastructures faced bad luck. An Indian Oil depot in Jaipur had caught fire and exploded in November 2009. You might have read about it in headlines. Well, Genus Power’s factory was situated adjacent to the Indian oil depot. The factory was badly damaged by the fire. They got insurance money for the damage but it resulted in a heavy production losses for a few quarters.

Now, who could have predicted this? Not even the best of analysts would have thought about such a risk. And even if they did, what was the probability of the risk becoming reality?

I would have thought it to be infinitesimally small. But it did happen.

There are some risks that you are aware of because you have studied the business of the company and current valuations.

There are some risks that you might have not captured in your study.

There are some risks you don’t know until they get realized. Like the Genus example.

You don’t want big decreases in your portfolio value because of one stock. This is a solid reason to diversify stocks.

The opposite is true too. You might miss out on big gains because of one stock. With diversification you do pay a small price in lost gains but more than make up for it in terms of peace of mind.

How many stocks are enough?

Are 5 stocks OK or too less?

How about 20?

Are 75 too much?

Like many other things in investing, there is no formula we can bank on.

The number of stocks should be guided by your investing style and the amount of time you have to study stocks. If you are guided by fundamental analysis you will spend time to study the business behind a stock.

It takes time to do justice in understanding the company and its attractiveness. Then you spend time to link this with valuation. There is a finite amount of time you have in your week after you come back from work or on the weekend. Unless, you are doing this as a full-time vocation, in which case, the time factor is different for you.

The time available will limit the number of stocks you are able to study.

It does not end with the stock purchase decision. You have to keep tracking developments in the stock at least on a quarterly basis to confirm whether the unfolding dynamics are as your expectations. You need to know when to sell as discussed in an earlier lesson.

Some thumb-rules are as follows:

  • 4-5 stocks would be a relatively concentrated bet.
  • 15-20 stocks is a decent number that you can study and track.
  • Beyond this number, as an individual, it might be tough to do justice to the analysis of stocks on a continuous basis.

For the last point I will not say, “too diversified”. If you see mutual fund portfolios you will see usually 30-40 stocks in an equity diversified scheme. They can afford to have so many because they have a team of full-time research analysts who track different sectors.

Diversification is truly a relative word. It has different meanings for different people.

Give an honest answer. Can you really do justice to 30-40 stocks on your own? I have seen portfolios which contain many stocks and the owner of the portfolio really does not know what is happening in the portfolio.

You will surely avoid such a state of affairs. You are learning prudent practices through this lesson.

 

Should I diversify across industry sectors?

Some sectors move in tandem. Some move independent of each other. IT companies for example are not as affected by what happens in India since they earn predominantly from foreign clients. Capital goods makers are heavily influenced by interest rates and the economic cycle in India. FMCG companies are usually resilient to downturns because people need to eat, use hair oil, have a bath and brush their teeth to put it simply.

Thus, if you take exposure to stocks across different sectors you are protected from adverse developments in one sector. For example, in the credit crisis of 2008-09, FMCG stocks came out relatively unscathed and bounced back. Many infrastructure stocks fell and never attained earlier levels.

If you were heavily exposed to the infrastructure sector before the market crash of 2008, your portfolio would be typically looking bad even today.

Sector diversification does help.

What is portfolio rebalancing?

Assume that you have decided to keep 10 stocks with maximum allocation of 15% to any one stock.

Suppose you start off the portfolio, you buy one stock which is 15% of the your portfolio value. You buy 9 other stocks which constitute 85% of your portfolio.

Suppose this one stock gains handsomely. Now when you look at your portfolio you see that this stock constitutes 20% of your portfolio. The other 9 stocks make up the balance 80%.

You are in breach of your 15% rule.

You would do good to sell some shares and bring the allocation back to around 15%.

You might feel that you are killing a well-performing stock. It still might have steam left as per your analysis.

It is a choice.

You can chose to ride on for more gains (which might come your way) but you have diversification has reduced. The portfolio will have greater exposure to this one stock and correspondingly be more affected by its movement.

Some people are OK with concentrated bets.

I am not claiming that any particular strategy is superior . If you are a beginner, a concentrated portfolio might be harmful for you in my opinion. As you gain knowledge, you can choose where you want to be between high diversification and high concentration.

Incidentally, I usually keep around 10-12 stocks in my portfolio. You don’t need to follow me blindly. Make your choices with complete awareness of the factors that are at play.

 

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