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Friday, January 13, 2017

To diversify, or not to diversify? That is the question.

Diversifying - in the context of business and investments - means hedging your bets, instead of putting all your eggs in one basket.

What is the main benefit of diversifying? Reduction of risk. Say, you are supplying large plastic containers to domestic paint manufacturers and have built up a reasonably good clientele.

Out of the blue, demonetisation of bank notes is announced by the government. The real estate sector goes for a toss and paint manufacturers curtail production. A big supply order of containers that you were negotiating gets cancelled.

What will you do? Shout from the rooftops about what an ill-planned disaster demonetisation has been? Or, realise the need of ridding the financial system of large amounts of untaxed cash and look for alternatives?

One alternative is to look for opportunities at other organisations in the domestic market with a need for large plastic containers - like Edible oil manufacturers. That would be a diversification.

Another alternative is to look for opportunities in the export market. A third alternative may be to make small plastic containers - used by shampoo and hair-oil makers.

Without making too many changes to your expertise and production capabilities, you now have more opportunities of growing your business and reducing risk by operating in different markets and product categories.

Peter Lynch coined the term "di'worse'ification" for companies that diversify into unrelated businesses that destroy rather than create shareholder value. A classic example?  Reliance entering the telecom services business. 

As if one brother's disastrous foray into telecom services was not enough. Now, big brother is throwing more money into the same business. The result is likely to be equally disastrous.

What about diversifying in the investment arena? Should you, or shouldn't you? Most financial experts will recommend diversification for reducing risk. That doesn't mean you buy 20 equity funds or 50 stocks.

Real diversification means investing in different asset classes after making a financial plan and an asset allocation plan depending on your goals and risk profile. 

Investing partly in equity, partly in fixed income, partly in gold, partly in a liquid fund will provide a well-rounded portfolio across different market and interest cycles.

When the stock market is booming, stocks will provide huge returns. What if the market crashes - as it often does? Fixed income instruments will continue to provide lower but steady returns, and liquid funds can be transferred to buy equity funds at lower NAVs.

Is there a downside to a planned and well-diversified portfolio? Unfortunately, yes. You will generate steady, average returns, but are unlikely to get filthy rich.

How can you get filthy rich? By becoming the next Bill Gates. Gates stuck to a single line of business, and made sure the whole world will use his company's software through shrewd negotiations with computer makers. (His di'worse'ification efforts into electronic products haven't borne fruit.)

Moral of the story? For mere mortals - like you and me - a planned and well-diversified portfolio that reduces risk and provides steady returns over many years is the route to financial freedom.

Learn more: 
What Does Investment Diversification Really Mean?

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