Diversification will reduce your profits

Diversification is the mantra for reducing exposure to risk in the markets. What this also means is that the potential to make sizable profits in the markets go down.

Don’t get me wrong, I am all for diversification. But, when diversifying, you should understand the fact that by putting your eggs in different baskets, you are reducing the chance of any one of them making your basket grow much bigger than it currently is.

Most people do not treat their stocks as companies that they own, and therefore are not able to think through “diversification” properly.

Let me give you an example of thinking through diversification. When I was going through annual reports of companies that produce capital goods, a common risk I noticed was rising input prices.

All these companies said that they had very little control over raw material prices and any rise in them will impact profitability.

So, the next thing was to find out what raw material they were talking about?

No surprises here, all the companies were using steel as one of the primary inputs and a rise in steel prices posed a big threat to their profitability.

Now if you have three stocks in your portfolio that use steel and the rising price of steel is posing a threat to their profitability, you should probably go out and buy yourself some good steel stock. That one purchase diversifies three stocks that you have.

If you think about stocks as businessses that you own, it becomes easy to diversify. After buying the steel stock, I realized that most of the portfolio was favoring capital goods and machinery and I did not have a lot of stocks that will benefit from retail buying.

So I went out and bought a fast growing retail chain store of India. That had me diversified across sectors. Doing this exercise a few times over helps you get a good perspective on your portfolio and how diversified you are.

The important thing is to think of your stocks as businesses and think about how they make their money. Once you think in that direction, it is easy to see which other businesses will profit, if this one was going down. Then go ahead and buy some stock of the leader in that business.

Researchers have come to the conclusion that if you select around 20 stocks carefully, you are diversified enough. Any more stocks after that number do not protect you from losses to a greater degree.

So, the bottom line is to think like a business owner and not over-diversify.