Diversification: The Pluses and Minuses

A lot has been said about diversification, where you spread your investments across various avenues. The plus point is that you don't have all your eggs in one basket, and that if one of your investments falters, another will balance it out.

Diversification in stocks means you buy many stocks, in many sectors. While that exposes you to a stock market crash, a fall in one sector doesn't usually hurt another. However you must be careful that these sectors don't impact each other; for instance, buying a steel maker and then a car manufacturer is not really diversification — a fall in car demand will hurt both sectors. Diversification is also employed by those that either have no time or skill to handle investing decisions themselves; often, it's known as a tool for the ignorant.
You could buy multiple asset-classes. Like Gold, real —estate, stocks, bonds, commodities and rare stamps. These asset classes, while providing a layer of diversification, often have varying liquidity problems. You can't sell a real estate investment in a hurry; and when stocks and bonds are down, you may find no takers for your gold either.
A mutual fund is, by definition, diversified. Each mutual fund invests in a bunch of stocks that their fund manager likes. Yet, people buy multiple mutual funds from different fund-houses, assuming that they shouldn't concentrate their bets on one fund. While having two funds might make sense for this purpose, it serves no useful purpose to have ten different equity mutual funds in your portfolio. If you were to do the (tedious) exercise of getting each fund's investments, revealed on their web sites every six months, you might find that the ten funds eventually have a significant overlap in what they own. Buying 10 funds, each of which has a strong weight to Infosys in its portfolio is not diversification.
To not diversify is also beneficial. Companies prefer to take loans from banks directly, instead of issuing bonds even if bonds would result in a far lower interest rate. Why? It's not just because we don't have a flourishing bond market — a bond market, though, can only flourish if enough companies issue tradeable bonds, which is a chicken-and-egg situation. Borrowing from a bank, even at a higher interest rate, has an advantage: If things go sour, you can always approach a bank to "restructure" the loan, increase the payment tenure, change the loan parameters or such.
What do you do if you issue bonds that are held by hundreds of faceless entities who change every day?
If you don't pay, you default. A default is a bad thing; it causes the bondholders to go to court, requiring you to sell whatever assets you have to make good on the loan. This action then forces other lenders, even banks, to have to demand their share. Most companies don't have enough cash to pay for whatever they have borrowed, and if they have sell whatever assets they own, the company then doesn't even have the resources to earn the money to pay.
But then, keeping your loans with the banks makes them arm-twist you, demand seats on the board, charge high random fees and in general reduce your ability to find a cheaper loan at another place. The risks of concentration are in the power that is held by a few. Recently, the Life Insurance Corporation of India (LIC) invested a large amount in a follow-on public offer of ONGC shares; it turned out that they were eventually the buyers of over 85% of all that was on offer, paying Rs. 10,000 crores (Rs. 100 billion).
Why were we outraged? Because the money is really the investment portfolio of many insurance holders, whose money is managed by LIC. Since we allow LIC to manage our money — through pension plans or life-insurance-plus-investment products - we face the risk that the capital can be misused or forcibly invested in avenues that don't deserve it. The problem is that we concentrated our bets in an insurance company, but we don't have the ability to withdraw (most insurance products penalize you heavily for early redemption).
You needn't diversify when you have the ability to influence returns. If you own a company, you probably have all your wealth concentrated in it, but that is not bad. You might have a good thing going, or massive growth on the way, and you know you can change track when things go wrong. A passive investment in Company X gives you limited visibility and flexibility; it is indeed better to put money where you know more and can react better. It is for this reason that a fund manager is expected to keep his wealth in the fund he manages.
An attempt to diversify can sometimes go horribly wrong. In the US, large banks bet on the housing market thinking that a fall in a house price in one area won't affect another. That bet turned sour as the market saw a large fall across-the-board. Certain banks converted loans to securities and then, split those securities into "tranches", which were then packaged into other pools of loans. You could then buy a piece of a pool of just the riskiest tranches which paid a high rate of interest but were given a "AAA rating". Because rating agencies believed diversification to be a magic wand that makes your risk disappear. It's only making the rating agencies disappear.
Finally, to borrow from Peter Lynch, you can diworsify. To buy into too many things means you need the effort to manage and track each of them, and the effort required can take away from your primary job. Or your investments can themselves diversify and muddle your portfolio. Venture funds in India made high profile investments in e-commerce firms, all of whom were doing different things ("deals", "books" , "fashion") and now each of them sells everything from bestsellers to toothbrushes. What started as a diversified investment is now a set of companies that cannibalize each other — to the extent that some are buying other companies just to shut them down.
A large healthcare company has big investments in a mobile phone company. A shoe manufacturer owns swathes of land it will convert into a commercial and residential real-estate business. An oil company owns retail stores that sell vegetables, a cigarette manufacturer owns hotels. Some of these will work, some won't — but it just makes it harder for you to really diversify.