Diversification

Some years back, I was attending a seminar for ‘Financial Advisors’ – which basically was a training for Insurance Agents on how to sell.

Got talking to a young lady there who was showing off her understanding of Financial matters and advised me “You should always diversify your investments – you should buy Shares, put money in Mutual Funds, Insurance policies, ULIPs, Bank FDs, etc, etc”. It was obvious that she did not have a clue of what she was talking about, but she was rather pretty, so did not have the heart to tell her that!

It is a common belief that “One should not put your eggs in one basket” and should hold a diversified portfolio. Now, most people take this to mean that one should have investments in various investments like – shares, bonds, real estate, etc, etc. In my opinion, this is a fallacy encouraged by the financial services industry. Say, I’m your financial advisor and I advise you to put all your money only in stocks and also advise you which stocks to buy, then you will concentrate totally on the share market and over a few years will pick up the nuances of that investment yourself and may not need me at all! If on the other hand, I steer you towards bonds, real estate, etc, etc, you will always need someone to guide you.

So, except for an emergency fund which should be in bank fds, I would say, “Put your eggs in one basket and watch that basket as if your life depended on it”. Does this mean one is not ‘Diversifying’?

We are very close to a group of builders – total ‘angoothachaaps’ – cannot write a word in any language except Gujarati and probably have 15 years of schooling – between the 3 of them! Only the fourth is a Civil Engineer. He explained to me how they diversify – it was an education to us.

For the real estate industry, there are only two phases – Teji and Mandi. During the boom times, rates increase much faster and hence, most people, especially investors buy at the ‘start of construction’ stage. However, during a down turn, the sales drop but do not stop altogether – people still need homes to live in. They buy ready to move in homes. There are two factors for this – they are scared that the builder may not complete the building on time and the prices are not rising that fast anyway.

So, how did these builders ‘diversify’? Very interesting. Suppose Project A is nearing completion and Project B is just about starting up, they will not sell all the flats in Project A. If the contruction cost of Project B is 5 crores, then they will keep completed flats in Project A that will sell for a total of around 5 Cr, even in a downturn.

They will start Project B and start selling flats there. As and when the flats get sold and the construction goes on, the requirement of keeping the flats in Project A reduces and they are slowly sold off!

Divesification is basically to maintain cash flow and these guys are doing a fantastic job of it.

So, diversification in Real Estate would be a combination of –

• Flats under construction – easier to sell during boom times.
• Completed flats – easier to sell during lean times.
• Low ticket value flats (around 40 lacs) – easier to sell generally, but low profits.
• High ticket value flats (above 1 cr) – more difficult to sell, but profits are higher.

Similarly, diversification in Shares could be a combination of –

• Large cap shares
• Mid cap shares
• Small cap shares
• Spread out across sectors
• Cyclicals

I end with a quote by Warren Buffett:

“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett

Happy investing!

Niranjan Bangera
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