If you are typical investor, you will prefer to buy diversified funds and create a diversified investment portfolio. Diversification is, indeed, one of the most misunderstood ideas in personal investment. In this article, we discuss some issues relating to diversification and show how you can create a simple diversified portfolio.
At the outset, the need for diversification appears logical. Your losses will be large if the only stock you hold declines in value. If you, however, buy different stocks and also invest in other asset classes such as bonds, real estate and commodities, the possibility of large losses is not so high. This is because the chance of different assets declining at the same time is small. Or so the argument goes.
There is a flip side to this argument. To create a diversified portfolio, you need to invest in assets that have a weak relationship with each other. That is, if your equity investments decline in value, your commodity investments should not. This also means that if your equity investments increase in value, your commodity investments cannot. Now, the problem is that relationship among assets change. That is, the assets in your portfolio may have a weak relationship during normal markets but a strong relationship during financial crisis or market crashes. You should look at how your diversified portfolio performed during 2008 sub-prime crisis. Except gold, which moved up due to “flight to quality”, most assets declined in value at the same time.
This is not to say that there is no virtue in diversification. You can enjoy the benefits of diversification if you apply sophisticated statistical models to create your portfolio. Given your lack of time and resources, it is moot if you can create such a diversified portfolio. So what should you do?
You should control your urge to diversify if your primary reason for doing so is to minimise risk. Why? For one, the changing relationship among assets means that diversification is unlikely to offer downside protection you expect during market crashes.
For another, there is the issue of selecting diversified funds. Often, such funds have broader benchmark such as the CNX 100 Index or the BSE 200 Index but invest in a narrower universe of stocks. A diversified fund’s portfolio risk may be, hence, different from that of its benchmark index and from its peer funds. This means choosing a diversified fund requires clinical analysis of various performance factors of all peer funds. Do you have the resource to engage in such a process?
Your investment objective is to accumulate wealth to meet your life goals such as buying a house or retiring rich. This objective should be achieved through disciplined savings. To the extent that you want to diversify, focus your attention on allocating your money across three asset classes — equity, bonds and commodity. Your core equity investment should be in one equity fund, preferably a style-specific fund such as a large-cap fund (read Nifty Index fund); an advantage is that a style-specific fund is easier to choose than a diversified fund. Your bond exposure can be primarily in bank fixed-deposits and tax-free bonds and your commodity investments, in gold ETFs. This process can help you achieve your diversification benefits, if any, without having to select diversified products.
The word diversification suggests low investment risk. But risk is not necessarily minimised during market crashes because relationship among assets becomes stronger when markets are stressed. Moreover, minimising risk has its costs — sacrificing returns during normal markets.
You, therefore, need to employ sophisticated models to protect your investment risk without sacrificing too much return during normal markets. So, rather than buying diversified products, it is simpler to create a disciplined investment approach to allocating money across three asset classes.
(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. Feedback may be sent to email@example.com)