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Diworsification: The trap no investor should fall into

The urge to hedge bets when it comes to asset classes or portfolios could lead to spreading oneself too thin, apart from the inherent risk of poor performance from a loss of focus. Consolidation may be a better way to go.

October 20, 2023 / 11:17 IST
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In his book 'One Up on Wall Street', the legendary fund manager Peter Lynch introduced the term 'diworsification' to describe companies' excessive diversification through acquisitions, often into unrelated businesses. Predictably, this led to substantial capital misallocation and destruction. Over time, the term has expanded to include over-diversification within an investment portfolio.

The concept of diversification, now firmly ingrained in the world of investing, is a fundamental element of Modern Portfolio Theory, initially formulated by Harry Markowitz in 1952. Diversifying across a variety of assets and stocks can reduce total risk, defined by volatility, while maximising the overall return in a portfolio.

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Total risk has two components: Systematic risk and unsystematic risk. Systematic risk encompasses market risks that cannot be mitigated through diversification. This includes geopolitics, macroeconomic factors like recessions, inflation or interest rates—essentially, risks inherent in the market.

Unsystematic risks are specific to individual companies or sectors and can be reduced through diversification. Examples include risks associated with management, strategy, business models, financial structures and operational factors.