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Diversification in Portfolio Management

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Portfolio Diversification

By: Tavaga Research

What does Diversification mean? Diversification meaning:

Portfolio diversification simply means not putting all eggs in one basket. In case your basket falls, all your eggs break. In diversification, what investors do is that they are splitting the risk of the portfolio over various asset classes so that if some of them go bad, the other good investments can cover up for the bad ones. This helps in reducing the risk of loss while not impacting the overall returns. The role of diversification is not to increase or decrease returns, the goal is to minimize your risk and get the best possible return with your risk profile. 

In your portfolio, diversification would mean investing your capital in multiple asset classes and not being largely exposed to any single asset class. A diversified portfolio will have equities, long and short-term bonds along some very liquid assets like gold. Within the equity asset class, selecting equities of various industries which exhibit little or negative correlation will be called a diversified portfolio.

Diversification within debt will lead to holding bonds of various maturities across government, PSU, and private sector bonds. Along with non-risky government-rated bonds, an investor can also hold risky bonds to get higher returns. In case the risky bonds do not perform well, the government bonds are there to cover up for the losses. 

In recent times, investors have also started to look at other avenues like real estate and cryptocurrencies to diversify their portfolios. 

What are the main risks that impact your investments?

Mainly, there are two types of risks: Systematic risks and Unsystematic Risks. 

Unsystematic Risks: Suppose you only buy stocks of the Automobile sector because of the rising demand for automobiles and high growth in the industry. Now due to some event, the price of oil rises rapidly making buying a car a tough decision. The profits of automobile firms decline and the share price of the automobile stocks goes down by a significant proportion. Your portfolio, which only holds automobile stocks, halves in its value because you did not diversify. 

Such risks that only impact a certain section or sections of the economy but not the economy as a whole is called unsystematic risk. Unsystematic risks can be reduced by diversification. Along with automobile stocks, holding stocks of other industries like banking, pharma or IT would have led to lower losses when compared to a portfolio that just had automobile stocks. 

To diversify the unsystematic risks, you should invest in industries that exhibit low correlation. Low correlation means that the prices of two or more stocks do not move in the same direction when presented with new information. According to studies, a portfolio of 30 stocks provides the maximum diversification benefit an investor can get. Above that, the portfolio risk remains fairly constant. An ETF that consists of an entire diversified index provides the maximum diversification benefit by eliminating all unsystematic risks.

Systematic risks: Systematic risks are also called market risks. Such risks impact the whole economy, like a pandemic hitting a country. Under such scenarios, the future outlook for all the industries is impacted and the value of even the most diversified portfolios goes down due to the negative scenario which has impacted the whole economy. 

While unsystematic risks can be diversified, systematic risks can not be eliminated from the portfolio. Even government securities like G-secs carry systematic risks, although the government has the authority to print more money to pay off these debts. Unsystematic Risk cannot be eliminated from a portfolio no matter how diversified the portfolio is. 

Source: Bogleheads, Tavaga Research

Foreign Equities in Portfolio Diversification

Equities that are listed on stock exchanges outside your domestic country are called foreign equities. For an Indian investor, foreign equities will equal stocks listed on the NASDAQ exchange in the US or on FTSE in London. Such stocks save your portfolio from a negative event that has happened in the domestic economy like a terrorist attack or political unrest. The correlation between domestic and foreign securities is low, reducing the total risk you take on your investments. 

Indians are not allowed to trade foreign equities directly through their Demat account. To add such stocks to your portfolio, an investor can either buy a unit of a Mutual Fund which invests in the country of your choice. Or an investor can buy an ETF index fund directly listed on the exchange. For example, the NASDAQ 100 ETF tracks the NASDAQ 100 index in the US. The shares of the ETF can be bought on NSE like other shares and incur a minimal cost. The benefits of foreign diversification overweigh the costs incurred on such transactions.

Diversification Within v/s Across Asset Classes

Investors can diversify by investing different amounts across various asset classes including equities: foreign and domestic, bonds, short-term investments, and cash and equivalents. To minimize your risk, it is best to invest across asset classes that exhibit low correlation with each other. When talking about picking investments within an asset class, investors can pick securities that depict high correlation. The high correlation within an asset class provides a high return from the asset, while the low correlation across various asset classes helps diversify the risk across various assets. 

How can various risk profiles help in portfolio diversification?

Portfolio diversification varies from one investor to another. It is based on your risk-taking capacity and expectations of future returns. An investor can alter the risk he is taking by changing the weights of investments he puts in various asset classes. 

Aggressive Portfolio

Aggressive portfolio is best defined by: High Risk & High Returns. It is suited for the ones who can endure more risk and volatility than usual. Such a portfolio puts more than 70% weight in high-return growth assets like domestic or international securities. The remaining investment corpus is invested into commodities like gold and fixed-income securities. 

Thus, an investor can diversify his/her investments with the help of domestic & international equities and a miniscule portion (around 10-20%) can be allocated to fixed-income securities and gold.

Growth Portfolio

A growth portfolio tries to provide constant growth to the investor’s corpus. A growth portfolio will have a relatively smaller amount put in equities as compared to an aggressive portfolio. On the other hand, it will have a relatively higher amount put in bonds and gold. This portfolio will try to provide superior returns than a balanced or conservative portfolio on the cost of higher risk it undertakes.

Balanced Portfolio  

A balanced portfolio, as the name suggests will have a balance between aggressive and conservative asset class, E.g. – 50% Equity, 35% – Debt, and 15% – Gold. Within equities, balanced portfolios usually have large-cap stocks which are less volatile and defensive in nature. Balanced portfolios are suited for people who want constant returns over the years and are risk-averse.

Controlled Portfolio

A controlled portfolio controls the returns and cash flows of the investments. Since cash flows are most predictable in debt securities, such portfolios have their major assets investments in government bonds that have the least probability of going bust. Smaller amounts are invested in large-cap equities and gold to take advantage of the higher returns but these funds derive most of their returns from bonds. 

Conservative Portfolio

A conservative portfolio will be suited for a risk-averse individual. Such portfolios only provide an inflation hedge by investing in gold and do not provide any additional returns. They are suited for people who have high liquidity needs and can not see their investment value decrease. The chances of loss by investing in such a portfolio are minimal. 

Portfolio diversification can be further achieved by investing your corpus regularly into various sectors and sizes. For E.g.: Investing corpus in small cap, mid, and large cap stocks as per the willingness & ability of an investor to take risks.

Sectoral diversification helps an investor during various market cycles. E.g.: In the current environment, an investor with exposure to commodities as well as Mid-cap IT stocks can generate better returns than an investor who is investing only into financials, autos or large-cap IT stocks.

Conclusion

Every investor should learn how to diversify a portfolio before they start investing. Diversification not only reduces the risk of the portfolio but also provides high returns in the long run. A diversified portfolio acts as a hedge against market volatility by not letting your investment corpus reduce to an undesirable amount. But diversification comes at its costs. A diversified portfolio will have to be churned regularly in order to main the asset allocation percentage. They also limit the gains an investor can make in the short run. 

All being said, the long-term gains from diversification are much higher than the costs incurred on maintaining such a portfolio. A diversified investor is also a satisfied investor. 

As a cautionary note: Over-Diversification reduces risk, but also leads to low returns in the long run. Therefore, always consult your financial advisor before investing in stock markets. 

Happy Investing!

 

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