As we are aware, diversification is about reducing your risk and not enhancing your returns. It is not about alpha, but about risk adjusted alpha. By diversifying you reduce your directional risk in the stock markets or in any other asset market. For example, if all your assets are going to move in the same direction then it means all your assets will give negative returns when the cycle turns down. This can be dangerous, especially if the down cycle is in progress when you goals are maturing. Then, your portfolio could see value destruction in a big way and hamper your goals. You can argue that they will give positive returns when the cycle turns up but ideally your investment strategy cannot be predicated on the likelihood. It must have an underlying plan and logic to it.

That is where diversification fits in because, the logic comes from diversification. Let us take a real time example of an equity portfolio to understand this point. If you are heavily invested in cement stocks and if the cement industry goes into a down cycle due to oversupply then your portfolio will underperform. So you add IT stocks and pharma stocks to reduce the risk of cement cycles. IT and pharma may be slow growers, so at the end of 3 years you may underperform a pure cement portfolio. But that is OK because it is a conscious trade off. What do we mean when we say that it is a trade-off? A diversified portfolio may underperform in specific cycles (you may lose out sectoral rallies). Over a longer period of time such a diversified portfolio will be much better off. In the medium term, diversification helps you to manage your risk and therefore enhances your risk adjusted returns.