Why you must never put all your eggs in one basket...

Why you must never put all your eggs in one basket...


When children are sent out by their mothers to shop for small home needs, one of the basic advice they give to the children is, “Don’t put all eggs in one basket”. The reason being that if the basket falls then all the eggs get damaged, a better idea would be to put these eggs in 2 or 3 different places so that at least some can be saved. At a very basic level, this is a call to spread your risk. In technical parlance, we also call it diversification. For example, you face risks at every point in time. There are risks in taking a job, there are risks in starting your business and there are risks in investing your money. The idea of not putting all the eggs in one basket is to ensure that the overall risk is managed better and even in a worst case scenario the investor has some positive returns to fall back upon.

What diversification is all about and here is how you go about it!

First and foremost; why should you diversify your investments?

The primary goal of diversification is to reduce risk and not to maximize profits.  It works like this. If you invest in asset classes that do not move in the same direction, at the same time or at the same pace, then you will reduce your chances of losing all of your money at the same time.  For example, if you had spread part of your money in equities into gold in 2008, then your losses on equity would have been partially compensated by the positive returns on gold and your portfolio would have done much better over a 3 year period. That is what is meant by not putting all your eggs in one basket.

But, how do I actually go about diversifying my risk?

When you diversify, don’t go about blindly adding assets. That is not the way diversification works. The assets need to be actually different. But how do we decide that they are different?  There are different ways to diversify. You can combine asset classes like gold or debt with equity. You can also spread across high rated bonds and lower rated bonds. Spread your money across mid caps, large caps and small caps. Also, ensure that your money is spread across sectors to reduce your sector dependence. The key in all these cases is to ensure that the correlation is as low as possible.

Diversification can be challenging because it requires investors to make an informed investment decision on a number of investments.  Those who do not have the time, knowledge or desire to do the research required for diversification can diversify using a mutual fund or an ETF. These are more passive ways of managing your money.  Through these vehicles, investors can delegate the research and selection process to the fund manager who pools funds and has more resources.

Just a question; can diversification go wrong?

Diversification can go wrong either if you do too much of it or too little of it. Let us understand. A portfolio invested 100% in equities can be risky even if it is spread among a diverse set of stocks You need other asset classes like bonds, liquids, and gold to enhance returns while reducing risk. The index risk in equities itself can be quite high.  Also if your diversification is done across sectors and themes that still have high historical correlations, then the diversification is unlikely to work. So correlation among assets is the key to getting adequate diversification.

How can we stretch on the other end? Warren Buffett called it “diworsification”. Typically, diversification works if you can add up to 12-14 stocks with correlation adjustments. Beyond that, you only have risk substitution and not risk reduction. At that point, the diversification by adding asset classes actually becomes redundant.

 

When it comes to spreading your risk via diversification, there are two basic things to remember. Firstly, if you do not have time, knowledge or desire to undertake and monitor the diversification, delegate to a manager like a mutual fund or a PMS or an ETF. Secondly, set Limits for yourself if you choose to go it alone.  To get the best benefits of diversification in equity, you must limit to 12-14 stocks across 4-5 sectors only. That is the Rule 101 of diversifying by not putting all eggs in one basket.