Importance of Diversification in Investments and Life

You have definitely heard the saying ‘Do not put all your eggs in one basket’ at some point in your life. Whether you eat eggs or not, this might be just about the most important proverb you will ever hear. The underlying logic is sound, inasmuch as it concerns eggs – fewer will break if you do not overload a single basket.

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But think of it in financial terms and the true meaning of it will become clearer.

There are a number of investment opportunities available today – Equity, Real estate, Fixed Deposits, Bonds, Government savings schemes, Insurance, Gold and more. Each has it’s merits and de-merits; some are safe but yield a low return, some have a potentially high return but carry a high risk of loss.

In such a time, it is essential to find a way to balance the risk with the return.

Intuitively, the diversification strategy makes sense to us. Allocate your money across the various types of investment avenues and you ensure you are neither trapped in a low-return investment nor subject to wild fluctuations due to economic cycles. Let a part of your funds flow into the safest investment – the Government-backed schemes like PPF, a part into Fixed Deposits and a part into the riskiest class, like Equities. Even within equities, the smart investor divides his money between safer stocks of blue-chip companies and the riskier ones of start-ups.

But beyond intuition, is the financial formula evolved by William Sharpe in his 1970 book, “Portfolio Theory and Capital Markets”. In this path-breaking work, Sharpe evolved the formula known as “Capital Asset Pricing Model’, or “CAPM”.

The formula is still commonly used to construct investment portfolios, and while getting into the nitty-gritty of the formula itself would take us into a technical discussion, which is not the scope of this article, suffice to say that the objective of the formula is to evolve a diversified portfolio in such a manner as to minimise the risk involved in investments.

Having said that, money is not the only area of our lives where diversification is important. Skills, reading, even the human networks we build – all of these are worthy of being looked as at as assets. After all, we hope to earn returns on these just as we do from financial investments!

So how would we apply the principles of diversification to our lives?

To begin with, do not become a one-trick pony. Knowledge is wonderful – immerse yourself in as many aspects of it as you can handle. Do not be stuck in a rut, specialising only in one skill, whether at school, university or at work. After all, to do well in school you needed to score marks in all eight subjects, not just one. In cricket, an all-rounder is more valuable to a team than a specialist, in football the coach looks for a player who can play on either flank.

When you enter the workforce, you typically have a degree. You have invested your time, money and brainpower into acquiring advanced knowledge in the world of finance, engineering or something similar. But in the first job role you get, it is likely you will be managing only a small part of a larger function. Maybe only testing of a certain part of a software module. Or only record keeping for a department. Or sale of a specific product.

It is tempting in such situations to remain stuck in that role, making it your own, investing all your time only into developing skills in that direction – in trying to make yourself indispensable. It is also the equivalent of investing all your money into a single company on the stock market. In today’s rapidly-changing world, jobs are temporary. Software has replaced many formerly-skilled roles, just as assembly-line manufacturing replaced artisans and robots replaced factory labour. To confine yourself to one role also means that if the role itself becomes obsolete, you could be helpless. If the product you are selling is withdrawn, you might find yourself without the skill to sell another. But even more significantly, the more diversified your knowledge is, the higher the likelihood you will be considered for promotions and greater responsibility.

And similarly across all aspects of life try to spread yourself out. The prices in one area may decline, but those in another are likely to rise. Always remember – it might be true that “When one door closes, another opens”…but you do need to have the wherewithal to walk through that open door!

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