Personal Finance: A Case For Diversification

With the stockmarkets bullish, you should be warned about two kinds of risk while playing in them: Overconfidence and Recency. Overconfidence comes easy; every investor considers himself to be, by definition, an above-average analyst.

Recency refers to the human tendency to weigh more heavily recent, even if incomplete, information, ignoring older, but more comprehensive, data. Many investors fall into the trap of transforming recent financial history into conventional wisdom. For instance, the Initial Public Offerings (IPOs) market boomed five years ago, and every financial analyst started recommending IPOs because of their superior returns. It is only now that people are realising that that was an aberration, which is not likely to recur, especially after the abolition of the Controller of Capital Issues.

Let us place this in historical context. In 1992, value stocks were popular; in 1993-94, IPOs did well; and between 1995 and 1997, debt was the preferred asset-class. In the last four years, the decline in interest rates and the gains from growth-stocks have left value stocks and smaller-cap equities in the cold. And, in the BSE 30 and the BSE 100, as well as the S&P CNX 500, the growth-oriented stocks are mainly the FMCG and pharma majors.

In 1998, only 8 of the BSE 30 posted gains--and all of them were either FMCG, pharma, or infotech companies. Expectedly, fund-managers are flocking to these 3 sectors; there are now 5 sector-specific funds focused on them. Actually, it is not unusual for one asset-class or investment style to dominate the stockmarket for a few years. While these sectors are the undisputed market-leaders at present, large cyclical stocks, small stocks, and real estate have all enjoyed similar periods of supremacy at one time or another.

When an asset class achieves short-term success, investors tend to believe that a long-term trend has been established, and overweigh it, little realising that such big-time investments could be dangerous. Actually, it isn't necessary to identify the best-performing asset-class every year; a simple diversification strategy can provide handsome returns with low risk. A diversified portfolio across sectors, market caps, and styles may not be the best strategy, but it will never let you down. Such a portfolio will show less negative years as compared to a concentrated portfolio.

Investors seeking long-term gains should invest in a diversified portfolio consisting of multiple asset-classes. By diversifying, you are in a better position to avoid extremes. To create a successful diversified portfolio, remember that each asset-class should represent a significant segment of corporate wealth. Keep in mind that, in any given year, your portfolio's returns may differ significantly from benchmarks such as the BSE 30 or the S&P CNX 500. But, in the long run, you are more likely to meet your goals by adhering to a consistent strategy of diversification.

It is tempting to careen in the face of short-term outperformance, and large-cap growth stocks are quite attractive right now. But, if you heed the lessons of history, these stocks are already showing signs of collapse. A diversified portfolio always makes better sense even if a diversified corporation doesn't always.

THE SENSEX'S TOP GAINERS & LOSERS
GAINS		LOSSES
Infosys	140.14%	IDBI	-60.91%
NIIT	139.31%	HPCL	-51.70%
Novartis India	117.02%	M&M	-48.64%
Nestle India	65.43%	Grasim	-47.85%
Glaxo India	51.01%	TELCO	-45.53%