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The D word!

July 6, 2008

seldom talk about the first Dee, which comes to people minds, at least in times like these. Downturn that is. Life is hard and making money is harder. And often when it seems you are just getting somewhere, there are a couple of party poopers [need names?] who make it sure you return home with an empty bowl.

Okay, enough of bickering and crying and cribbing. Time to get our hands dirty and portfolios clean. In fact, from a purely philosophical and contemplative mood, I would say, these are the times to actively cleanse your mind, body and portfolio. What we say as shuddhikaran[purification that is].

Purify the mind, of all the worries of downturn. Purify your body of all those beer you had when the going was good, making money was simple, air was clean and sex was dirty. Sorry but those days are gone, and put that beer belly out too.

And lastly, clean,spruce, cut, file away or whatever adjective you might like to add, to actually do, the job you have been advised for the nth time. Yeah and thats precisely the D word, I would like to talk about today.

Diversification of your portfolio. Its an interesting job by the way, and one which definitely doesn’t have straight answers. We are having some wee bit of stagflation in our ways. No second opinion. Stocks are falling and portfolio is increasingly plunging into red, deep red.

Your investment strategy was choose some, bet big, haul rich.

And thats precisely where the mistake was made. This type of investment strategy works extremely well in bull run, perhaps because even first grade idiosyncrasies are awarded in a bull run [and thats why everybody loves bulls], but this simply fails in a bearish phase.


You think, that by having a core portfolio consisting of a chosen few stocks will beat the market? 🙂 Good for you, but its not that easy. Often, the volatility of such portfolio is higher than the index. Hence when during a bull run, index is soaring at 11% rate [just a sacrosanct figure], your portfolio shows an appreciation of 25%. But unfortunately, when the index falls, the portfolio falls sharper. And the latter case is most visible in non diversified portfolios.

Okay, question time: How do you actually go about diversification process?

Okay, junta. Its not that simple. Complex mathematical variance calculations and Sharpe ratio calculations fill the pages and then you can actually have a relief of figuring out the variance or risk or how much diversified your current portfolio really is. To tweak, to manage and to improve it, requires a rocket scientist.

So did you get scared yet?

No? Then read that again. Yes? Then ignore it 🙂

Although, diversification and fine-tuning a portfolio for the risk-reward ratio is fairly complex, but it doesnt really need a rocket scientist to figure out two diversified, decoupled industry. At least thats the only thing you can do practically. And it just requires two things: Common Sense and Understanding.

So a quick quiz: Which two industries are more decoupled- Ice Cream and Rain Coat or Semiconductor and PC industry?

The answer will be Ice Cream and Rain Coat Industry. A common understanding says, if it shines, then ice cream sales usually [leaving myself a wiggling space] goes up, and if it rains then the latter. So if it rains or shines, having both of them in your portfolio will manage to offset each others slumps! And you are better off.

Happy? And you think, that’s all diversification? No. Diversifying is often a tougher job than we might think. Is Finance Sector decoupled from any industry as such? After all, finance is the lifeblood of a growing economy. And hence the second requisite kicks in. Understanding.

Once the understanding grows, we really stop looking from the sectoral point of view but start looking from a company point of view. YES BANK [YES]  has interests in venture capitalism and private equity, while SBI [SBI] has a whole lot of exposure on agri side. ICICI BANK [ICICIBANK] has mixed exposure. So whom to choose and whom to not. Often, an intuitive understanding works miraculously. And better yet, hire a good fund manager.

But these two are rare to find. Rarer in these days of snake oil salesmen and dubious accreditation.

But you do have a fantastic diversified portfolio already made for you, my dear reader. [And no I am not selling any product of my own!]

You have INDEX FUNDS for you to invest in.

INDEX FUNDS, what are they?
Professionally and well researched indices are nothing but collections of top performing corporates in individual sectors, all different and decoupled of course,weighted average by their market cap.Surprisingly the NAV is in extremely close tandem with the index. Heck! it is the index.Just assume, NIFTY is the merger of 50 companies which form the index, of course the merging companies have shares in this maha company in accordance to their market capitalisation. And you bought one share of this maha company, then in effect you own one share of NIFTY. Or in other words, one share of an index.

But you have got a problem at hand. NIFTY shares are not sold in open market, only its FUTURES are sold. So go for the next best thing: Invest in an INDEX FUND. A mutual fund emulating the entire Nifty index.

So, next time, when you try to look out and shop for some index funds, check out their tracking error. Or intuitively speaking, how closely the fund is in tandem with the index.

On a parting shot, although these are not recommendations, but some place to start searching is a good enough stepping stone to start with. Here listed are some of the index funds:

[The author, Soham Das takes a passionate interest in business innovation,electronics and environment. An avid blogger and technology guy, he spends most of his time studying charts or bringing up projects for his employer. When he is not blogging on markets, technology and their business issues, he spends his time conceiving and executing projects for a hi-tech electronics startup based out of South India. Mail him at sohamdas at gmail dot com. He is listening]

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  1. The D word!

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