You have heard the saying “Don’t put all your eggs in one basket.” By diversifying your portfolio, you decrease the risk in your overall portfolio by reducing the exposure you have to a single asset class. What Is Diversification? Diversification is the process of investing a portfolio across different asset classes in varying proportions depending on an investor’s time horizon, risk tolerance, and goals. While diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses, this disciplined approach does help alleviate some of the speculation that is often involved with investing. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. What is the difference between Asset Allocation and Diversification? Asset allocation is the process of developing a customized, diversified investment portfolio by strategically mixing different asset classes in varying proportions. Asset allocation is based on the principle of diversification, but takes the process one step further. Diversification spreads money across different investments. Asset allocation, by strategically diversifying a portfolio among different asset classes, potentially offers investors a double advantage: • To benefit from changing market cycles • To reduce overall portfolio risk by offering a higher degree of diversification Asset allocation therefore aims to reduce the “ups and downs” associated with investing and makes it easier to stick with investors’ long term investment objectives and avoid market timing How should you go about Diversification? Finding the right diversification strategy depends on personal choices and circumstances and can’t be limited to a formula. It has to be a dynamic exercise and should be revisited frequently. Here are some factors that can help you adopt the right strategy. 1. Goal timelines are important: Start by evaluating the financial objectives for the next 10-20 years. Mark each objective in terms of priority and quantify the money required. For goals which are at least ten years away, you can take higher exposure to riskier assets. For goals that are a year or two away say buying a car or going on a foreign holiday it makes sense to preserve capital and go for debt investment avenues. Taking too much exposure to equity in short term could be risky. The Nifty’s 50% correction in 2008 is a case in point. 2. Risk profiling: The level of risk you are willing to take is a crucial factor. You willingness to accept a level of risk doesn’t mean its appropriate for you. Aggressive investors look for growth in value and if you are conservative you will lean towards capital preservation and regular income. You don’t have to define your allocation in two extremes but set your limits somewhere in between. 3. The right asset: If the above two factors are sorted out, the choice of the asset would automatically fall into place. Typically equities are considered as long term assets and fixed income for earning regular income. Any goal above 5 year qualifies for an allocation to equities and goals with shorter time horizons are better catered to by debt Mistakes one should avoid 1. Don’t sleep over the portfolio: Building a diversified portfolio is just half the job done, its just as important to rebalance at appropriate intervals. These intervals can be defined by time, value or when you are closer to achieve your financial objectives. 2. Don’t chase returns: For rebalancing look at the overall portfolio. Don’t just look at returns. To benefit from a suitable strategy one has to demonstrate discipline in following it through market cycles over a period of time. Advantages of Diversification Diversification across asset classes like debt, gold, other commodities, etc, help in reducing volatility of the overall portfolio. What works to the advantage of the investor is the low correlation between some asset classes. For example, the equity markets fell by more than 50% in 2008, whereas some debt funds returned 27% in the same year. Commodities like gold have very low correlation with both debt and equities. However, a diversified portfolio may not get the best return with respect to the other asset classes but it will also never be the worst performer. One needs to understand this while investing. Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic recovery in the U.S. economy may not be impacted by weakness in Indian economy therefore; having U.S investments would allow an investor to have a small cushion of protection against losses due to an Indian economic downturn. Minimizing risk It is risky to have all your money invested in one asset class. Let’s consider equities. Albeit over a longer period say 10 years, equities have the potential to deliver 10-15% CAGR. In shorter periods returns can be volatile. Say you had invested your entire surplus of Rs.10 lakhs in equities in 2008, with the market crash you would have lost around 50% in one year thereby eroding the value of investment to almost half of the entire corpus. Now let’s imaging you have a diversified portfolio of 50% equities, 30% debt and 10% gold and remaining 10% in your savings account. In the second scenario you would have lost close to 20% vis-à-vis the earlier option. So clearly a diversified approach helps limit losses when returns are falling. Since it is impossible to gauge in advance how the market will move it is prudent to have your surplus spread across different assets and balance risk and return. To temper market volatility Diversification reduces portfolio volatility because various asset classes typically perform differently under the same market conditions. When bonds are up, stocks often tend to be down and vice versa. By combining asset classes, volatility is reduced. This helps to smooth returns and limit losses due to overexposure to volatile market segments. In short, diversification enables the investor to achieve higher returns with less risk and volatility. Strategy 1. Diversify your Portfolio across Asset Classes Recent history has shown that it is increasingly difficult to generate positive returns by investing in a single market or type of investment. No investors, regardless of investment experience, can consistently predict the following year’s top performers. Year Stocks Bonds Gold 1995 -23% 3% 14% 1996 -1% 13% -3% 1997 20% 24% -14% 1998 -18% 8% 8% 1999 67% 16% 2% 2000 -15% 13% 1% 2001 -16% 25% 6% 2002 3% 23% 24% 2003 72% 12% 13% 2004 11% -1% 1% 2005 36% 6% 22% 2006 40% 6% 21% 2007 55% 7% 17% 2008 -52% 27% 31% 2009 76% -6% 19% 2010 18% 6% 24% 2011 -25% 6% 31% 2012 28% 12% 9% Source: Bloomberg Stocks: CNX Nifty, Bonds: I-Sec, Sovereign Bond Index, Gold in INR 2. Follow a disciplined Asset Allocation Strategy Asset allocation strategies are key drivers of investment results - Investors are often surprised to learn that a significant percentage of the volatility of investment performance is driven by asset allocation decisions – combining asset classes such as equities, bonds and cash in varying proportions within one customized, diversified investment portfolio. Factors such as when investors commit assets and which securities they buy are considered to have a relatively small impact on long-term investment results. Keep monitoring your asset allocation strategy and rebalance the asset allocation based on market performance. Example: If an aggressive investor, aged 30 and with an investment time horizon, has the following asset allocation, Equities – 50%, Debt – 40% and Gold – 10%. Assuming Equities deliver 50% returns in the next 1 year, Debt 10% and Gold also 10%, the asset allocation will become Equities 57.7%, Debt 33.8% and Gold 8.5%. Investor should rebalance the portfolio again to go back to the earlier allocation of Equities – 50%, Debt – 40% and Gold – 10%. 3. Investing in Mutual Funds At this juncture, one of the biggest impacts of volatility is that it increases the entry-point and exit-point risks in investing. The simplest way of tackling this risk is to invest through the systematic investment plan (SIP) route. By investing in the market at regular periods of time, irrespective of the levels, we can achieve cost averaging and also participate in the long-term upward trend of the Indian markets. Benefits of SIP – The chart below shows how SIP helps reduce market volatility as it buys more units when markets are lower and less units when markets are higher. Month Fund NAV Lumpsum Investment S.I.P Investment Investment Amt Units Allotted Investment Amt Units Allotted 1 10.0 1,000 100.00 12,000 1,200.00 2 8.00 1,000 125.00 3 6.00 1,000 166.67 4 6.00 1,000 166.67 5 7.00 1,000 142.86 6 8.00 1,000 125.00 7 9.00 1,000 111.11 8 10.00 1,000 100.00 9 11.00 1,000 90.91 10 11.50 1,000 86.96 11 12.00 1,000 83.33 12 13.00 1,000 76.92 Final Units 1,375.42 1,200.00 Investment Value 17,880.51 15,600.00 4. Investing in Stocks 1. If you are investing directly through stocks, then it is better to stick to the stable large-cap blue-chip companies during volatile times. These companies have proven track record and, hence, have higher probability of wading through tough times in case of turmoil. 2. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate. In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n=30 Number of Stocks in Portfolio Average Standard Deviation of Annual Portfolio Returns Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock 1 49.24% 1.00 2 37.36% 0.76 4 29.69% 0.60 6 26.64% 0.54 8 24.98% 0.51 10 23.93% 0.49 20 21.68% 0.44 30 20.87% 0.42 40 20.46% 0.42 50 20.20% 0.41 400 19.29% 0.39 500 19.27% 0.39 1000 19.21% 0.39 Follow a disciplined Asset Allocation Strategy Source:Investopedia
Posted on: Tue, 09 Jul 2013 06:33:55 +0000
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