About Eggs & Baskets : Some Notes on Diversification



You cannot start on diversification without a clear understanding of the Risks you are seeking to manage. That is why I spent some time commenting on the definition and nature of Risk and the ways to measure Risk Management performance. In layman’s terms, the usual term is Return, the opposite of Risk. Most investors are focused on Return, realizing Risk only when it happens.

Declaimer: This article was written in May 2007, and some of the data points may be outdated.

I defined Risk as the probability of things going wrong. Once things have gone wrong, they cannot go right. Older investors will remember this feeling they have after their losses, of wanting to turn the clock back. It is the same feeling you get after losing a loved one when you want to reach out and touch the person after she is gone.

Risk “Management”, therefore, is a bit of an oxymoron. If Risk is managed, it is not there, i.e., things go ‘right’. The whole point is, that if Risk is still there, Risk CANNOT be ‘managed’. Think about this for a long time, you might agree that this is a very significant observation.

Risk can only be anticipated, avoided/ obviated, and measured (in an imperfect manner). The management of Risk has two dimensions: curative and preventive. The curative part is really about surviving Risk, which is not the subject of this article. The preventive part is all about ‘diversification’, almost the only way to ‘manage’ Risk as defined in Financial markets.

Both Risk measurement and diversification (a.k.a. Portfolio Theory) lend themselves to mathematical and statistical analysis, giving Classical Finance its biases.

Value investors and Behavioural Economists tend to focus on a philosophy towards Risk, which is softer and more nebulous than the normative approach in Classical Finance. I will try and lay out some of these elements for you.

Double Or Quits?

 Quite simply, never (either Double or Quit). You must remember that in Russian Roulette, you cannot KEEP playing. Even if you are right 5 times in a row, you have to be wrong the sixth time. And the only time you are wrong, you will be dead.  In the same manner, you should never assume that you will always be right on the stock market. Mature investors always play the markets with their worst-case scenario laid out.

One takes a long time to figure this out. You take a long time to try out different trading strategies, then you get a high ratio of successful trades. This time you start to make good money. Now greed takes over and you start to believe that you will always get it right. This is the time when you are most prone to play the “double or quits” game. I know someone who got 814 trades right (successively) in a single run, then went on to lose everything in the next 5 trades (when Ketan Parekh went bankrupt).   Please pay attention to this principle, especially if you already have a good right-to-wrong ratio.

Mind you, this is not to be confused with the philosophy of ‘stop loss’. Short-term traders exit the market when the momentum turns against them, mainly because they are basically ‘momentum’ riders. Stop Loss is the point at which you can’t take any more loss, or you don’t trust the momentum (reversal) anymore.

Value investors do the opposite. They add to their positions as a scrip goes down, playing to be the ‘last man standing’, i.e. trying to buy the last falling share as sellers depart the stock. The more of these ‘last’ shares they can pick up, the better their returns, provided of course, they have bought a safe, steady business at a great price, and the business recovers subsequently.

Correlation & Diversification

 Like buying a truck and car company together. That should be obvious to everyone, but how about a truck and a housing construction company together? In hindsight, you might realize that they are both linked to the Interest Rate cycle.

Sometimes people diversify into other assets that are themselves correlated with each other. In the above example, trucking and housing look different, but the underlying drivers of demand (in this case, credit availability) may be the same.

Diversify What You DO

Fewer people do this than you would imagine. In the stock market, most retail investors are usually only buying shares, never short-sold on the market. As a general principle, there is much to recommend this strategy…..I feel that if you get a short-sold position wrong, your Risk is unlimited. Imagine short-selling Infosys in 1998…..!

But if you take a somewhat correlated portfolio, you can achieve a genuine reduction in Risk levels. Recently, I was short on the Nifty but was bought on a low-Beta portfolio comprising the likes of Reliance Energy, Tata Steel, Tata Power, Hero Honda, and ITC. On the downside, the portfolio had a Beta of 0.3, but on the up, it outperformed the Nifty. Overall, when the market dropped 15%, I lost a maximum of 5%, but when the need came up, the portfolio outperformed the Nifty. I call this phenomenon ‘Beta migration’. I was able to make money on both legs, by shorting the Nifty and by the increase in value of my bought portfolio.

Over short periods, this is mostly an art, not suitable for everyone. But over long periods (say, 5-10 years) it is a well-known principle that almost any portfolio constructed of low-Beta stocks will outperform a portfolio of high-Beta stocks. This should be obvious to any believer in human irrationality. High- Beta is usually achieved with high Volatility, lots of froth, and glaring media attention (remember the IT Boom?)…….and we know how that went!

In this strategy, you should try to trade a correlated pair as part of your diversification strategy. Like buying the market leader and short-selling the market laggard. A caution here is that if you are buying at the bottom of the cycle, then the laggards gain more than the market leaders. In a bull market, buying the market leader and short-selling the laggard may be a good trading strategy.  Make sure that you don’t make a mistake in reading the market………for example, is this a bull market or a bear? I looked at the Interest Rate cycle and thought it was the start of a bear market, but somebody argued that India is the only major country in the world with high and rising costs of capital. Across the world, the cost of capital will soon start to drop. That would suggest a very shallow bear market if we see one at all. Even a normally ‘bearish’ person like me is not willing to take a stand.

Other Comments

Statistically one thing is clear – traditional means of diversification won’t save you. Remember one common mistake: mindlessly diversifying into, say, 100-200 stocks, which then go unmonitored for entry and exit points. Since the investor no longer knows enough about these businesses, he is prone to fall prey to rumors. In effect, the act of ‘diversifying’ will increase the probability of losses rather than reduce it.

True diversification includes far more investment choices than just stocks and bonds. It includes other non-correlating asset classes that don’t intrinsically involve speculation or timing. I recommend keeping up to 15% of your portfolio in cash if you have devoted 60% of your Net Worth to stocks, including derivatives. The rest can be in Real Estate and personal effects. Aggressive investors like the readers of this magazine must be having more than 50% of their Net Worth in equities, especially if they are below 40.

With each investment be sure to invest no more than you can afford to lose, so you can sleep at night. And use Rupee cost averaging – taking a fixed proportion of your savings each month to add to your investment holdings, so that volatility becomes an advantage over a long time horizon.

Only then will diversification begin to make statistical sense



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