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Why Diversify?
April 21, 2009

Most financial advisers will encourage investors to diversify their investment portfolios. Does diversification really work?


Author : iFAST Research Team



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You hear it so often. Most financial advisers will encourage investors to diversify their investment portfolios. In actual fact, does diversification really work?

Diversification involves splitting up your money so that it can be invested in different kinds of investments. Put simply, it means not putting all your eggs in one basket. But some investors may argue that if all their money was to be placed into one 'good' investment, they would achieve the 'maximum' amount of returns. But that is only with the benefit of hindsight. In reality, it is difficult to predict the investments which will deliver the 'best' profits in the future.

WIDER EXPOSURE AT LOWER RISK LEVELS

The uncertainty in the investment world may have led some investors to place all their monies into safer investments such as fixed deposits. Others may adopt another extreme way of investing by putting all their monies into just one high-risk investment. Both methods are not advisable. The latter is akin to betting, while the former means forgoing good investment opportunities. The benefit of diversification is that it gives investors a wider exposure to various investments at a lower risk level.

We set out a simple hypothetical example below:

In this instance, there are 5 possible investments, labeled A, B, C, D and E. At this juncture, each of these investments seems like it can deliver good returns. For investors who choose to avoid investing in all 5 investments, but put their monies into fixed deposits instead, they could be forgoing several potentially good investment opportunities. For investors who decide to put all their money into just one of these investments, their chances of making it big is around 1 in 5 mathematically, or just 20%.

Let’s see what happens to the portfolio if we diversify it by splitting our monies into 5 equal portions and invest them in the 5 investments, namely A, B, C, D and E.

Table 1: Investment allocation

Investment

A

B

C

D

E

Amount Invested

Rs. 5,000

Rs. 5,000

Rs. 5,000

Rs. 5,000

Rs. 5,000

Let’s now assume that these investments are left untouched for 20 years and the investments had reaped the following annualised returns:

Table 2: Assumption for annualised returns

Investment

A

B

C

D

E

Annualised Return

+15%

+5%

0%

-5%

-15%


After the 20-year holding period, how many of you are thinking that the diversification exercise was a total waste of time because you are back at where you started with the original Rs. 25,000?

In reality, you might be surprised to find that the actual amount of your total investment holdings, including profit, after 20 years, based on the above returns, is Rs.102,085! This is four times higher than the original investment amount.

the power of diversification

The portfolio has now effectively delivered an annualised return of 7.3% on average each year. How could the portfolio deliver such good returns when it appeared the portfolio should have made no gains at all? Let's consider the following illustration:

 Table 3: Value of Investment After 20 Years

Year

Fund A

Fund B

Fund C

Fund D

Fund E

Total

0

Rs. 5,000

Rs. 5,000

Rs. 5,000

Rs. 5,000

Rs. 5,000

Rs. 25,000

1

Rs. 5,750

Rs. 5,250

Rs. 5,000

Rs. 4,750

Rs. 4,250

Rs. 25,000

2

Rs. 6,613

Rs. 5,513

Rs. 5,000

Rs. 4,513

Rs. 3,613

Rs. 25,250

3

Rs. 7,604

Rs. 5,788

Rs. 5,000

Rs. 4,287

Rs. 3,071

Rs. 25,750

4

Rs. 8,745

Rs. 6,078

Rs. 5,000

Rs. 4,073

Rs. 2,610

Rs. 26,505

5

Rs. 10,057

Rs. 6,381

Rs. 5,000

Rs. 3,869

Rs. 2,219

Rs. 27,526

6

Rs. 11,565

Rs. 6,700

Rs. 5,000

Rs. 3,675

Rs. 1,886

Rs. 28,827

7

Rs. 13,300

Rs. 7,036

Rs. 5,000

Rs. 3,492

Rs. 1,603

Rs. 30,430

8

Rs. 15,295

Rs. 7,387

Rs. 5,000

Rs. 3,317

Rs. 1,362

Rs. 32,362

9

Rs. 17,589

Rs. 7,757

Rs. 5,000

Rs. 3,151

Rs. 1,158

Rs. 34,655

10

Rs. 20,228

Rs. 8,144

Rs. 5,000

Rs. 2,994

Rs. 984

Rs. 37,350

11

Rs. 23,262

Rs. 8,522

Rs. 5,000

Rs. 2,844

Rs. 837

Rs. 40,494

12

Rs. 26,751

Rs. 8,979

Rs. 5,000

Rs. 2,702

Rs. 711

Rs. 44,144

13

Rs. 30,764

Rs. 9,428

Rs. 5,000

Rs. 2,567

Rs. 605

Rs. 48,363

14

Rs. 35,379

Rs. 9,900

Rs. 5,000

Rs. 2,438

Rs. 514

Rs. 53,230

15

Rs. 40,685

Rs. 10,395

Rs. 5,000

Rs. 2,316

Rs. 437

Rs. 58,833

16

Rs. 46,788

Rs. 10,914

Rs. 5,000

Rs. 2,201

Rs. 371

Rs. 65,274

17

Rs. 53,806

Rs. 11,460

Rs. 5,000

Rs. 2,091

Rs. 316

Rs. 72,673

18

Rs. 61,877

Rs. 12,033

Rs. 5,000

Rs. 1,986

Rs. 268

Rs. 81,165

19

Rs. 71,159

Rs. 12,635

Rs. 5,000

Rs. 1,887

Rs. 228

Rs. 90,908

20

Rs. 81,833

Rs. 13,266

Rs. 5,000

Rs. 1,792

Rs. 194

Rs. 1,02,085

Annualised Returns

+15%

+5%

0%

-5%

-15%

+7.3%

Source: iFast Compilations

In the first year, we see that the portfolio delivered exactly zero returns. However, as the years passed, the worst performing investment formed a smaller part of the total portfolio, while the best performing investment became a bigger part of the portfolio. Eventually, the compounded returns of investment A, (and to a lesser extent, investment B) helped the portfolio to deliver good overall returns.

This highlights both the power of compounding as well as that of diversification. On seeing the individual returns, some might think that the investments chosen for the above example were terrible. Two out of the five investments lost money consistently, and investment C can be likened to placing your money into a drawer! Even investment B was not that impressive, as it only returned 5% per year – nothing to be exceptionally excited about! However, the power of diversification has allowed the portfolio to reap an annualised portfolio return of 7.3%.

Thus, when you diversify your portfolio, not all your investments have to make it big; you may just need some of them to succeed.

Fund Managers’ Widely Employed Strategy

Diversification is what fund managers usually attempt to do with their stock selection, and this is also the reason we advise investors to diversify their investments. In the examples we have examined, diversification could ensure that we would get a good return for our portfolio, even if two of the selected investments performed badly, and one was the equivalent of stashing your money away under the mattress!

In reality, it is also unlikely that an investor will end up with an investment that consistently loses money in every single year for 20 years. He would most likely have switched out from this investment long before the period of 20 years was up! At the same time, it is also not easy to have an investment that delivers annualised returns of 15% over 20 years.

Nevertheless, the above illustration was meant to highlight to the investors the concept of diversification and to show why it works statistically. Through the examples, we hope investors will realise why the concept of diversification is extremely important. This principle allows you to invest with greater confidence, as not all your investments will need to be huge winners in order to obtain good overall returns for your portfolio.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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