Diversification and long-term, these two phrases are often clubbed together in the world of investments and wealth creation. What does it really imply? It is generally considered that since equity is a long-term product to create wealth, we can simply reduce our risks by diversification. But does that simply imply that if we just create a diversified equity portfolio, that portfolio is bound to do well in the long-term?
To start with, it is very challenging for a professional fund manager to beat the index returns. And if we look a bit close, we see that broadly the indexes are well diversified, but even diversified indexes themselves have not given very outstanding returns when compared to other monotonous asset classes like bonds and gold which are considered a bit less risky than equity, and of-course return expectation must be higher from equity than from these other asset classes. If we talk about India, the Nifty-50 (including dividend) has given approx 10% CAGR since its inception in 1995. On the other hand, gold and bonds also have given 8 to 9% CAGR in the same period. An almost same story can be observed in the US markets as well, over the last 40-50 years. So just creating a diversified portfolio and sitting on it for the long-term is not enough. Now the question is, how have these successful and smart investors generated good returns in their portfolio then?
Let’s start with the world’s most renowned name in terms of consistent wealth creation- Warren Buffett. In its March’ 2020 filing, Berkshire Hathaway (Warren Buffett’s flagship investment company) has reported that close to 70% of its total holdings are concentrated in just 5 companies. They don’t believe in wide diversification, and Mr. Buffet himself has correctly said that “Wide diversification is only required 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 a majority of their holdings are invested into very few companies. It is never as simple as to invest in many companies or create a diversified portfolio and wait for the long term. We need to increase the weightage in outperformers consistently. Let’s say a typical diversified portfolio comprises of 15-20 stocks, but the real returns are actually generated by no more than three or four stocks, and the weightage of these stocks should eventually become the majority of that portfolio. If that doesn’t happen, then the three to four outperformers will more or less be canceled out by the three to four underperformers inside that same portfolio, and the overall long-term returns will never look very promising.
(Prashant Dhama is Executive Director & Board Member at iVentures Capital, a Sebi-registered broking and wealth management company.)