Diversification, the only Free Lunch in Investment

There are very few things in our life that are truly free. Everything that we consume in the form of products or services has to be paid for directly or indirectly and instantly or down the line. It is only air that is free to some extent. The bottom-line is that everything has a cost. This is the reason we simply do not believe in all the emails that we receive somewhere from Nigeria or London about a lottery that promises a fortune. Nonetheless, in investing there exists the notion of a free lunch. Nobel laureate Harry Markowitz is credited with coining the phrase ‘diversification is the only free lunch in finance’.

The reason behind such wisdom is that by investing in diversified assets or instruments your risk gets reduced without sacrificing much on the expected returns. Diversification helps in managing your downside risk. The extent to which it will help in reducing the risk will depend on how closely the assets or the portfolio are correlated. Lower the correlation between them, higher will be the benefit of diversification. In the current environment when the equity market world over is trading at an all-time high, including India, it make sense to invest in a diversified portfolio.

This is because no one knows when this party will stop. Although a well-diversified portfolio will help you in protecting from a large drawdown, it will also lead to lower returns than a concentrated portfolio. Nevertheless, it is still advised to invest in a diversified portfolio in the current circumstances. As such, in this issue our cover story covers the most diversified equity mutual funds among all the four top categories. It will help you to pick the right fund at the current point of time with better risk-reward ratio.

SHASHIKANT