NATURE BACKS DIVERSIFICATION IN INVESTMENT
I am very interested in Nature and love everything about it – its timeless beauty, unsurpassed wisdom and the priceless lessons it attempts to teach investors. All these amazing attributes are founded on the principle of ‘diversification’. Nature comprises various elements – weather, plants, animals, us human beings, the rivers, the seas, landscapes and so on. A common feature of each constituent element is ‘diversification’. For example, there are various seasons: summer, autumn, winter and spring. Human beings come in their varied colours, heights and sizes, plus a multiplicity of temperaments. Nature unceasingly wants investors to embrace one mantra – ‘diversification’.
Why does all-wise Nature keep going on and on about its philosophy of ‘diversification’? There must be something good in it for the investor, whatever deal the Great Teacher has got to offer! What really is the benefit? I will walk you through some concepts of investment in a moment to help throw some light on the matter.
A basic principle that underlies investment is that there is a trade-off between risk and returns. This means that if one takes a high amount of risk he/she can expect to enjoy a proportionately high return and vice versa. Risk measures the probability of obtaining the expected returns. There are primarily two types of risk namely systematic or market risk and unsystematic risk. Systematic risk is unavoidable and is common to all firms. It has to do with broad factors such as inflation, interest rate changes, political instability and so on. Unsystematic risk on the other hand, is based on inefficiencies in a particular firm, such as poor management, high employee turnover, etc. This kind of risk, however, unlike market risk, can be avoided through ample diversification. The relationship between risk and return is normally explained by the Capital Asset Pricing Model (CAPM) which is a further development of Markowitz’s Portfolio Theory (MPT). The word ‘portfolio’ is the term used in investment theory to designate a collection of chosen securities. According to CAPM, an investor is only rewarded for the systematic risks on its securities and not its unsystematic risk. The justification for this is that when an investment is sufficiently diversified – comprises a combination of anything between about 15 to 20 securities, then all the unsystematic risk is more or less diversified away. In effect, all that there will be left to reward, is the systematic risk, over which the firm has no control. The essence of diversification is therefore to reduce risk, whilst still ensuring the attainment of the expected return.
In fact, diversification as a tool to cut down on risk does make sense. Firms in whose securities investments are made, are affected differently by various changes in the economy. Some firms do really bad during economic decline, and perform well, when there is economic boom. Other firms, however, rather perform well when there are economic hardships, and under-perform when things are good. There are also the ‘all-rounders’, that excel irrespective of what the economic situation is. Different industries suffer a similar fate. Even in the most successful organizations, things can turn really grim. Nature is the epitome of this. Consider the magnificence of the rose flower in its varied shades of colours; yet it is not without its thorns! It is a good idea to invest in assorted securities in dissimilar industries, so that loses in certain securities can be made up for by the gains in others. Variation in the types of securities dealt in is also crucial.
There isn’t much to be gained from putting all of one’s eggs in the same basket. Let’s assume you own a considerable amount of some high-quality, sparkling diamonds, and lived alone in your own house, in a deprived area, with high risk of theft. Would you hide all the diamonds in the same place? You can answer yes; but I wouldn’t. I will hide them in different places to increase my chance of having some left for me, should my house get burgled. This is all diversification is about; to reduce risk, yet maintaining or enhancing returns.