Diversified or Deworsified

Amar Pandit , CFA , CFP

At a basic level, people understand diversification as “Don’t put all your eggs in one basket”. It is such a simple and powerful concept. The devil though lies in your literal interpretation and implementation of this concept. There is an art and science behind diversification, but few understand this. On the other hand, I have seen many investors innocently murdering this simple concept and turning it into deworsification.

While there are many examples of deworsification, let me give you an example you might be able to relate to.

Rahul Muzumdar, a business owner in his late fifties, considers himself to be a savvy investor. So does Arun Mohanty, a 30-year-old professional in the pharmaceutical space. There is a common thread between Rahul and Arun. They both think diversification means investing through different people or platforms. Rahul invests through 2 banks, 1 stockbroker and 2 mutual fund distributors while Arun invests through 3 online platforms.

We have one architect/designer for our house, we have 1 doctor for our heart or 1 doctor for our eyes or children but when it comes to money, some people have 2-3 financial professionals. It is like hiring one designer for your living room, another for your bedroom, a third for your kitchen and so on. This is the stupidest way of designing your house. Yes, you can always take a second opinion, but you will first spend your time in finding the right architect for your house.

Likewise, investors should invest time first to evaluate the right financial professional for them. However, this is easier said than done and thus investors do what is easy. They think of diversifying and end up doing some form of Naïve Diversification- Have More Professionals. Spread your investments across more professionals (Just some form of Risk Management). A common line used by investors is “I will give you X amount of money. Let me see how you perform.”

Distributing money across many professionals is not just Naïve Diversification; It is Deworsification at its best

There is no co-ordination between the various entities, they constantly engage in a game of one-upmanship thereby taking more risk than necessary and overall creating a very inefficient and ineffective portfolio.

Imagine 4 heart surgeons trying to operate on you simultaneously. What do you think the outcome will be?

The real issue Rahul and Arun both have is that they do not know who to trust. Thus, they think diversifying trust across people might help. The reality is that Trust can never be distributed in any way. I trust A 20% and B 50% and C 30%, or I trust them 33.33% each. There is no concept of diversification of trust.

The following made up equations should be useful for you.

Deworsified Portfolio Construction = Pitch from Bank + Pitch from Real Estate Agent + Pitch from Life Insurance Agent + Pitch from Stockbroker + Pitch from Mutual Fund Distributor

End Result = Hodge Podge of Products

Real Diversified Portfolio Construction = GPP = Goals First, Plan Second and Portfolio Third.

Here is a simplified process for a Real Diversified Portfolio Construction:

  1. Goal Setting: Done at the Outset – The Why
  2. Plan: Nothing but a Series of If-This, Then That Statements. This is hardcoded and rules based. You can also call this an Algorithm.
  3. Portfolio: based on the Above Goals and designed with the Plan
  4. Goals Updated Annually, Goal Achievement and New Goal Formation.
  5. The Circle Continues

End Result = Living the Life you have imagined with your Money

Another deworsification mistake by Rahul, he invests a small amount in several mutual funds. He has more than 60 mutual funds in his portfolio. The key thing to remember here is that a mutual fund is a diversified way of investing in a basket of stocks, bonds, or cash. Buying 7 Large Cap Funds is not Diversification. You get it right. It is Deworsification.

A portfolio can never be diversified truly by distributing money to different people or just spreading money across many similar investments. Diversifying a portfolio is about constructing a house with a solid foundation. The stronger the house, the stronger the foundation needs to be. A step before you lay the foundation – identify a real professional who will help you lay the foundation – achieve real diversification.

Your role is to bring the best professional. Best in the case means not only Skill wise but most importantly Care Wise and Trust wise – someone worthy of your trust.

Are you Diversified or Deworsified?