Diversification and long-term, these two phrases are often combined together in the world of investment and wealth creation. What does this really mean? It is generally believed that since equity is a long-term product for creating wealth, we can reduce our risks by diversifying. But does this simply mean that if we only create a diversified equity portfolio, then that portfolio is bound to perform well in the long term?
To begin with, it is very challenging for a professional fund manager to beat index returns. And if we look a little closer, we see that the index is well diversified broadly, but even the diversified index did not give very spectacular returns compared to other monotonous asset classes like bonds and gold. , Which are considered slightly less risky for equity. And certainly the expected return should be higher than equity compared to these other asset classes. If we talk about India, the Nifty-50 (including dividend) has given a CAGR of around 10% since its inception in 1995. On the other hand, gold and bonds have also given 8 to 9% CAGR in the same period. The same story can be seen in American markets over the last nearly 40–50 years. So just building a diversified portfolio and sitting on it for a long time is not enough. Now the question is how have these successful and smart investors generated good returns in their portfolio?
Let’s start with the world’s most famous name in terms of coherent wealth creation – Warren Buffett. In its March 2020 filing, Berkshire Hathaway (Warren Buffett’s major investment company) reported that close to 70% of its total holdings are concentrated in just 5 companies. They do not believe in broad diversification, and Mr Buffett himself has rightly stated that “extensive diversification is needed when investors do not understand what they are doing”. Smart investors know that diversification hurts long-term investment performance.
Successful investors invest in many stocks but many of their holdings are invested in very few companies. It is not as easy as investing in multiple companies or building a diversified portfolio and waiting for long periods. We need to continuously increase the weightage in the outperformers. Explain that a typical diversified portfolio consists of 15–20 stocks, but the actual return does not actually exceed three or four stocks, and the weight of these stocks should ultimately account for the majority of that portfolio. If it does not, three to four outperformers will more or less be canceled by three to four underperformers within the same portfolio, and overall long-term returns will never look very promising.
(Prashant Dhama is an executive director and board member at Sebi-registered broking and wealth management company of iVentures Capital.)