Whether you manage your investments on your own or engage an adviser, you should be familiar with diversification. For most, diversification is investing in several equity mutual funds or multiple bonds and fixed deposits to minimise risk.

But are you compelled to diversify when you are confused or offered several investment choices? We discuss why you should not always feel compelled to diversify.

Diversification issues Suppose you ‘knew’ that your mutual fund investment will generate 12 per cent return every year for the next 25 years. Further, suppose you require 10 per cent return per annum to achieve your retirement goals.

You have to simply invest in this fund to reach your retirement goal. Why bother about other funds? Of course, the reality is far from this.

You do not know how your investment will perform. To reduce the risk of depending on a single fund to achieve your life goal, you buy several funds.

But buying several funds by itself does not diversify investments. For instance, all your investments could react similarly to adverse market developments — say, an economic slowdown that can affect automobiles, the bank sector and the airline industry. This leads to two important questions. One, is diversification beneficial despite a globalised world where businesses are interconnected? Two, if so, how should one diversify?

This question is important because relationship among assets change with market conditions. Commodities and stocks, for instance, have stronger relationship during global crisis than in normal markets.

And because it is difficult for you to measure such relationships, should you diversify?

You should always have stocks and bonds in your portfolio. If you need money after 9.3 years, you should invest in a 9.3-year bank deposit.

That way, you will ‘know’ the cash flows you will receive at maturity. But you should also invest in equity to enhance the returns on the portfolio.

When to avoid That said, should you have five equity mutual funds or fixed deposits in ten banks? Not always. The following are some situations when diversification is not so compelling. One, your portfolio consists of public sector bank fixed deposits. Now, even though, say, PNB’s financial health is different from that of, say, IOB’s, both are strongly related to the government.

So why hold fixed deposits in several public sector banks? While such diversification offers emotional satisfaction, the effort involved in tracking the maturity dates and renewing the deposits may be tedious.

In the second instance, you invest primarily in index equity funds. Now, all Nifty index funds hold the same stocks and generate similar returns. Such funds differ marginally only in their cash holdings. So why hold different index funds on the same benchmark?

Third, you buy diversified mutual funds. If such funds diversify properly, they may all have similar portfolios! So, why buy five such funds?

When in doubt Most of us diversify because we feel compelled to do so. Behavioural psychologists call this tendency diversification heuristics. That is, when in doubt, we diversify using thumb rules or short cuts.

This is not to suggest that there is no virtue in diversification. It is just that you should diversify only when it is beneficial.

Further, you should do so using sophisticated models and not by simply applying heuristics. So, if you are a retiree and your portfolio contains deposits in large public sector banks, it is hard to see a compelling need to diversify.

(The writer is founder of Navera Consulting. Feedback may be sent to >portfolioideas@thehindu.co.in )

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