Why we diversify

We prefer to spread our risks but often we diversify more than required. What compels us to diversify?

Suppose you are looking to invest in a diversified equity mutual fund with a three-year investment horizon. You manage to narrow your choice to three funds. How will you choose among the three funds?

If you are certain about how these funds will perform in the next three years, you will obviously choose the one that offers the maximum return. But you are investing in an equity fund, where the returns are dependent on the market and on the fund manager’s skill. So, you will most likely divide your total investments equally among the three funds, because you will know if your decision to choose a fund was appropriate, only after three years! What if you invest all your money in one fund and it turns out to be the worst performer? Dividing your money across three funds, on the other hand, provides you the comfort that you will not lose all your money even if one fund declines.

But have you really reduced your risk? Perhaps not. The reason is because all three funds are diversified funds that typically invest in the same universe of securities.

Diversification heuristics So, why did you do it? You were suffering from diversification heuristics. That is, we typically diversify when we are uncertain about our decision outcomes, even if diversification does not always reduce risk! Likewise, the fear of how interest rates will move prompts us to invest in fixed deposits of different maturities with the same bank.

The urge to diversify is equally compelling when we are faced with choices. Suppose, a restaurant asks you to choose in advance breakfast for your next three visits. You are unlikely to choose the same breakfast for all three visits even if your preferred menu is on offer. But what if the restaurant allows you to choose on each visit? You will most likely have your preferred menu on all three visits!

Sometimes, it is the availability of choice that compels us to diversify. When you have to choose five bags of potato chips at the same time, you are unlikely to choose all bags of the same flavour, even if your preferred flavour was available! It is typically the delay in feedback from uncertain outcomes and presence of choice that drives to adopt diversification heuristics.

(The author is the founder of Navera Consulting. Feedback may be sent to >knowledge@thehindu.co.in )

COMMENT NOW