Diversification – Meaning & Significance

In the June 26 edition of Points to Ponder, it was suggested that FIIs were rushing out of Indian stock markets to chase markets that were in the forefront of AI Induced capex super-cycle. Yet there have been assertions that India with its well diversified market, was offering a contrarian bet. The unfolding AI rout seems to confirm this, at least for now. It is not that only Korean market that is devastated by the meltdown in AI related stocks. Given alongside is a list of 16 companies which are front-runners of the AI theme which have, over the last 52 weeks, lost a whopping $ 6 trillion in market cap.

For an investor then, it becomes important to construct an investment portfolio which can not only survive such meltdowns but manages to grow in spite of them. One way to mitigate such risks is to diversify the investment portfolio. But when it comes to constructing an investment portfolio for an individual, it becomes quite easy to confuse variety with diversity. One of the oldest nuggets of investment wisdom tells us not to put all our eggs in one basket and modern investing has made it wonderfully easy to buy lots of baskets. The problem arises when we discover that those baskets contain many of the same eggs.

I have an investor friend who has invested in a large cap fund, a flexi cap fund along with a couple of ETFs, backed up by balance advantage fund and a small cap fund. However, during the last one year or so, all the constituents of his “carefully diversified” portfolio have been moving in the same direction; downwards.

Well, a portfolio which comprises many names might provide an illusion of diversification of risk.  To ensure that one is not misled by such an illusion, while investing, one has to distinguish between manager diversification, fund/security diversification and risk diversification. All these methods of diversification have their uses. But when it comes to diversification of risk per se, it is essential to find out how various assets in the portfolio behave in relation to one another in a given situation. In other words, the investor wanting to diversify risk has to ask the question if assets constituting the portfolio are inversely correlated and to what extent. At least ascertain that they do not move in the same direction when circumstances change as when inflation spikes or interest rate falls, rupee weakens or, Indian equities get de-rated or even when investors suddenly are unwilling to take risk. Equities, high quality debt, gold, international assets and cash can respond differently to the above developments, although none offers guaranteed or constant relationship. The table below delineates how asset classes have behaved though various situations over time.

For the first half of 2026 diversification emerges as the winning strategy. But overall, when investment horizon is extended, gold and silver have topped the returns table across periods ranging from one to seven years. On a 10 year basis, the S&P 500 takes the top spot, while India’s Midcap 150 ranks second. No wonder more and more fund houses have jumped on the “Multi Asset” bandwagon!