The Hindu Business Line : There may be no virtue in portfolio diversification

THE S&P CNX Nifty declined nearly 7 per cent in one month. It is in such times that the traditionalists extol the virtues of portfolio diversification. A principle reason for the diversification is to spread the market risk and earn higher risk-adjusted returns.

Such diversification can come through exposure in various asset classes or through exposure in number of securities across the same asset class. In either case, the objective is to construct a portfolio with assets that have low cross-correlations. This article, however, argues that portfolio diversification may no longer be a virtue given the shortening of investment horizon.

Portfolio diversification: In the Markowitz mean-variance state, an optimal portfolio is constructed with stocks that have low cross-correlations and high returns potential. Importantly, investors are expected to hold the portfolio for a considerably long period.

The problem is that the time horizon has reduced considerably in recent times. A diversified portfolio constructed with long-run relationships may not be optimal for such short time horizons, as correlations among stocks are time varying.

Moreover, correlations are unstable over the short run. So, even if a portfolio is constructed with short-run relationship, it may not be optimal in the mean-variance state. The foundation on which portfolio diversification rests, hence, fails. But question is: Has time horizon really collapsed?

Collapsing trading horizon: The cumulative quantity of shares traded on the NSE during 2004-2005 was nearly five times that of the shares traded in 1998-1999.

The percentage of shares delivered did not, however, keep pace with the sharp rise in traded quantity. This, indeed, is a signal that traders are flipping their portfolio more often.

Another sign is the increasing volumes in the futures segment. From cumulative market-to-market settlement value of Rs 1,740 crore in 2002-2003, the value jumped to Rs 13,000 crore in 2004-2005.

Clearly, more people are comfortable taking bets in the futures segment, where the trading horizon is less than a month. The sharp under-reaction and over-reaction to earnings surprises is yet another indicator of the short-term behaviour of investors. Finally, consider the increasing demand for recommendations from technical analysts. So, the next question is: why has there been a collapse in time horizon?

Risk-return space: The general notion that stocks outperform other asset classes in the long run is not always true. What if the first few periods of investment turn out to be bad?

Consider this. The maximum drawdown on the Nifty spot index was 600 points between February and May 2000. That is, a third of the value was wiped off in just three months.

What if a long-term portfolio was constructed just before the decline? Such a portfolio would take years to recover the capital losses let alone outperform other asset classes.

The point is that asset prices follow discrete jumps. And such jumps have been more frequent in recent times. A buy-and-hold strategy is not optimal in such market conditions.

Moreover, bond market return has stabilised at 6-7 per cent, adding pressure on the equity portfolio to generate more short-term gains. A structural shift in the risk-return space is, hence, forcing investors to think short term.

Even mutual funds resort to portfolio flipping to generate excess returns over their benchmarks.

This is not to suggest that all equity investors have short trading horizons. Some do buy stocks for the long haul, but the majority does so for short-term trading.

Loss-aversion and disposition effects could force some traders to extend their otherwise short-term horizon when faced with losses. But that is quite different from buying stocks with a long-term objective.

In a short trading horizon, spreading bets may not be optimal. With clear entry and exit strategies and money management tools such as the trailing stops, traders prefer to take concentrated bets to increase returns.

As Peter Bernstein referred to it in a different context, diversification will turn out to be di-worse-ification for traders with short trading horizon.

(Feedback can be sent to bvenky@thehindu.co.in)

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