Diworsefication of Portfolio
Diversification is the most widely acclaimed investment principle for wealth accumulation. Every stock broker suggests it because it is so simple that even a 10th grader can understand it. We briefly discussed about it in “Principles of Wealth Accumulation” as a subtopic named “Don’t put all your eggs in the same basket”.
Diversification means allocation of your corpus in different asset classes namely, stocks among different sectors, mutual funds, debt funds, cash, gold ETF, Index ETF, overseas funds etc. according to your convenience, age, risk taking ability, target corpus and the timeline to achieve financial freedom. It is indeed a good investment principle to minimise volatility & maximise rewards with minimum risk to beat an average investor. A healthy diversified portfolio is like a shock absorber in panic times since it correct sharply but to lesser extent and recovers early to give much higher returns when compared to an index viz. NIFTY 50, BANKNIFTY etc.
But should you stress too much on diversification? No, because overstressing leads to diworsefication of your portfolio. Pros of diversification are accompanied by some cons also which we will discuss here briefly.
The disadvantage of having eggs in so many basket is that a lot of eggs do not end up in really attractive baskets and then it becomes impossible to keep watch on each of the baskets.
Having a large number of stocks let’s say 25 or more looks appalling but the fact is that very few stocks among them are really attractive which its investor or his advisor has high degree of knowledge.
Some stocks in your portfolio belong to different sectors but they are interlinked because of a specific macro parameter. For example, a cement stock and a paint stock both are inflation affected stocks. Meanwhile, they belong to different sectors but once inflation hits, they both plunge together.
Analysts have oversold the diversification principle to investors that fear having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in companies which they barely know about. Buying a company without sufficient knowledge of it may be even more dangerous than having inadequate diversification.
Afraid of Buying on a War Scare
Every-time a war has broken out stocks plunge sharply downwards and rebound sharply as the war scare subsided giving much higher returns than before. Investors overlook the long-term aspect of a war scare which causes them to dump stocks on the fear of war and its arrival even though by the end of war the stocks have gone much higher than lower.
Modern wars causes governments to spend far more than they can even collect from their taxpayers while the war is being waged. This causes the currency, such as INR, to become worthless than it was before. It takes lots more INR to buy the same shares of stock. This is a classic form of inflation.
In other words, war is always bearish on money and to sell on outbreak of a war scare so as to get into cash is a financial blunder. Instead you should do the exact opposite of it. This is the time having surplus cash for investment is least desirable since war increases inflation and you lose your purchasing power.
How fast should you buy and when?
Buy slowly on every dip on war scare.
After the arrival of war, increase your tempo of buying significantly.
Make sure you buy into companies which benefit from war or demand for their product and services will continue in wartime.
Don’t overstress highs and lows of a stock
You must have seen people arguing about 52 week high and lows of stocks and why you should buy it near their lows and sell near their highs. Well it’s important to know the history of stock to forecast its future, but it has nothing to do with how the stock is going to perform in future.
The point which is of real significance is that the price is based on the current appraisal of the situation. Therefore, the price at which stock sold 5 years ago may have little or no relation to the price at which it sells today. The company may have developed a host of new abled executives, a series of newly and highly profitable products etc.
Similarly, many investors will give heavy weightage to the per-share earnings of the past five years in trying to decide whether a stock must be bought or not. Again what counts is the knowledge of background conditions. An understanding of what will happen in next several years is of overriding importance.
The investors are fed with reports and so-called analyses largely centered on these price figures for the past five years. He should keep in mind that it is the next five years’ earnings and not those of the past five years’ that should matter to him. One reason why investor is fed with these reports is that it is not hard to be sure that these stats are correct. If more important matter are gone into, subsequent events may make the report look quite silly. Therefore, there is strong temptation to fill these spaces with indisputable facts, whether or not facts are significant.
Don’t fail to consider time in buying a true growth stock
Suppose you found an outstanding stock with excellent past performance and is expected to perform well for the next several years. The financial community is completely unaware of it. The stock is trading at an expensive price-to-earnings ratio i.e. the price is way to ahead of its earnings due to the ventures in the prior years. The stock is priced at 40 eventually 100% more than it would had been in the absence of ventures and influences i.e. reasonably priced at 20.
Many investors would watch closely the intrinsic value of the stock i.e. 20 and if stock got near 20 they would buy it eagerly. Otherwise they would leave the shares alone.
Is the figure of 20 sacred for investors? No, because it doesn’t take into consideration an element that many people are unaware— the future value which in few years will justify the value of 100. The concern people show here is that if they buy at 40, the stock may depreciate to 20 not only leading to temporary loss alone. More significant, it would mean if the stock appreciates to 100, for their money what matters more is averting loss of 100% of shares if they could have waited and bought at 20.
Perhaps when a new venture reaches its pilot plant stage, this positive influence is reflected in its stock price long before its commencement. Why not plan to buy these shares five months ago before venture reaches its pilot plant stage. Under these circumstances it’s safer to buy at a certain date rather than a certain price.
However, when the indications are strong that the an increase about to come, deciding to buy on a future date rather than the price at which you will buy may bring you a stock with extreme further growth at or near the lowest price at which that stock will sell from that time on.
Leave a Reply