There are two types of risks that you as an investor have to plan for, Systematic risk (market specific risk) and Non-Systematic risk (stock specific risk).
Diversification is the strategy to deal with non-systematic risk (stock specific risk). Let’s us understand this with an example, imagine you have a collection of 20 stocks and if one of those 20 company goes bankrupt you will not lose your entire capital since you are diversified to 20 stocks. Hence it helped you to reduce risk related to individual stocks (Non-systematic risk).
Asset allocation is the strategy to deal with systematic risk. Systematic risk is not a stock specific risk, it affects the whole market almost equally. For example, War, natural disaster, risks arising from these factors can affect any stock equally. To deal with this risk you have to diversify across markets or across asset classes. Remember the earlier article on asset allocation, i.e. dividing your investments across stocks & bonds can help you deal with market specific risk.
Many critics of Diversification says it is “settling for mediocrity”. When you adopt this strategy your returns are averaged out. Even if you observe the top investors like Warren Buffet, they are not very diversified they own 10-12 good businesses and they own them for lifetime. A typical mutual funds is diversified to around 50 stocks, so you see top investors don’t diversify a lot.
The question is should you implement Diversification strategy or not?
If you are a person who understands a business really well and have conviction over its future and most importantly you have the stomach to absorb the wide fluctuations in value. You can very well be less diversified and make way higher returns than a diversified portfolio. But if you belong to that segment where you are not very clear on business fundamentals and more importantly not trained on your behavioural aspect, (the more your portfolio turns red, the more you freak out), This strategy will give you a sense of comfort and will help you keep away from taking wrong decisions at wrong time.
The most efficient way to diversify a stock portfolio is by owing a low-cost index fund. The main advantage of owing an index fund is “Over the last 10 years, 86% of actively managed US stock funds underperformed index, over the last 20 years 90% unperformed the index.” This data is not readily available for Indian funds, but the performance will be somewhat similar.
Let me know in comments whether owing an index fund makes sense or not?