Being good at one thing or being called as a specialist or a subject matter expert may have an adverse impact when you have the same strategy in constructing your wealth portfolio.
Having one stock that creates wealth for all your financial needs is a nearly impossible thing someone has ever achieved. Maybe a bitcoin owner who sold in 2017/2018 peak 😊
Wow!! A good scary note to start an article. Hang on.
I have written this as a two part series covering What and Why in the Part-1 and How and Samples in Part-2.
Having a strategy is always good in whatever tasks you do. Having one strategy to identify the asset class for generating wealth is also good. However, having only one asset class in your entire portfolio may back fire you. Hence, this article on portfolio diversification.
What is diversification
In order to understand diversification, let’s step back to a very old method of trading (VAANIGA / VAANIGAM) called as commodity exchange. With this method, one would produce a commodity (Rice) and exchanges it with someone who has one more commodity (Wheat).
If the accumulation goes up and in such a way rice is not being liked by the other party then the first person is left with one commodity.
In order to overcome the challenges in commodity trading, currencies were introduced which became an implicit way of trading. If there were ONLY one currency then again we will be running in to same problem of excess one currency. (Bitcoin is a different story).
Similarly, if your portfolio consists of ONLY one asset class, then there is a high probability that the problem of accumulating the same would destroy your wealth creation strategy.
Why to diversify
In the journey of wealth creation one has to clearly understand the difference between assets and liabilities. Without understanding the difference between these two there is a high chance that the person is following a wrong strategy for wealth creation. Once the difference is known, only then assets may really add value to your portfolio.
Assuming the difference is clearly understood, let’s talk about why diversification is needed referring back the same example stated above.
Let’s consider a person think’s “Gold” as an asset class and starts accumulating it. Over a period of time his entire savings has gone in accumulating it, and after his earning capacity has reduced he starts thinking to convert it to cash/currency. Imagine yourself in this situation and try to answer how does this feel ?
Not bad. An whopping >500% returns considering for last 20 years. Check this here
But, wait a moment. This is not an ideal scenario where you get returns like above. Greed inside everyone of us will anticipate higher returns than this, and hence will hold more than the waiting time. This is where one will fail during the exit though the discipline of Investing carried over for a longer period.
If the Investment had been diversified to various asset classes, then one may not have to worry about the above said additional waiting period.
What parameters to be considered
I hope it’s clear on the need for diversification in a simpler common man terms. However, let’s also touch upon few parameters like Inflation, rate of returns, your age.
Assume the journey of accumulating gold. One might have started with 500₹ during 1990 and would have accumulated 8 gm of gold. The same 500₹ invested every month till 2020 would have yielded much lesser quantity. Let’s say 0.10 gm of gold.
I observed it. You blinked your eyes twice. 😊. YES. This is called inflation.
Now, imagine yourself in >500% returns. You were happy with this return percentage, but once you converted it to a currency the returns it yielded would be much lesser since the quantity of Gold every year started declining too.
Over twenty plus years spending 500 every month you might have only saved 40gms of gold.
Let’s see, how to diversify and few sample portfolio’s categorised age wise in the next article.