The Hindu Business Line : Spread and diversify

An asset class that has performed well may see a sudden reversal in returns and vice-versa. That’s why it’s important to spread investments across different asset classes.

A.V. Pai

Over the last couple of years, Pratiksha, a young professional, invested a lot of money in equity and equity-oriented funds to ride the booming stock markets. She saw her money grow by more than 60 per cent in a year. However, since January 2008, as the markets started to tank, her portfolio value slumped. She met Jayanti, a financial advisor who suggested fixed maturity plans (popularly known as FMPs) as an attractive investment option.

Pratiksha sold stocks and redeemed mutual fund units to invest all her money in FMPs. The indicative returns offered by FMPs were 8-9 per cent. But, recent reports of FMPs being hit by redemption issues prompted her to exit that too. She switched to gold bars and units in gold funds. They also saw a sharp depreciation within a month. Now, with someone pointing out that banks are offering a good return of 10.50-11 per cent, Pratiksha is considering a switch to bank deposits.

This example goes to show that most people tend to invest their money in the asset class which has given the highest returns at that particular point in time. The basic assumption for this strategy is that an asset class will continue to do well if it has done well in the immediate past. However, that is not the case in real life. An asset class that has performed well may see a sudden reversal in returns and vice-versa. That’s why it’s important to spread investments across different asset classes.

Key asset classes

Diversification is important because each asset class has its own features. The key distinct features of an asset class are: Return; risk; and liquidity. Investors need to have a clear picture of risks and rewards that go with investing in each one. Some asset classes provide liquidity, some security, some steady income, some capital appreciation and some windfall gains.

The key asset classes for an Indian investor are: Equities, equity-oriented mutual fund, fixed deposits, debt funds, commodities and real estate.

Even within a broad asset class there are sub-classes. One must diversify suitably across these sub-classes too. For example, in debt one may invest suitably in bank FD, NSC/KVP and PPF etc. Or in equity, one can diversify across large-cap, mid-cap, small-cap, sector-specific funds.

Steady asset allocation

Based on one’s risk profile and financial goals, a proper asset allocation strategy must be decided upon. Periodic monitoring to see if assets are in line with the asset allocation strategy decided helps.

Uncorrelated assets

Spreading investments across uncorrelated assets offers the best diversification. By investing in uncorrelated assets, one can better the returns in a volatile market too. For example, when the equity market was down, gold showed an upward trend.

Don’t chase returns

Don’t try to increase returns by investing in a class of assets which gives the maximum return. At times, the returns may be at the cost of risk to the capital. From the example of Pratiksha, we saw that she was investing in equities when the market was nearing its peak. At that time, it looked as if the equity party will continue forever. But with the credit crisis, the domestic stock markets have gone down by more than 50 per cent over the last nine months. Such reversals can be difficult to predict, hence the need for asset allocation.

Liquidity

Certain asset classes may not score high on returns, but they provide liquidity, e.g. liquid funds. Some investments can also be offered as collateral for bank loans, e.g. NSC, Kisan Vikas Patra, insurance policy, thus generating liquidity when you need it. With real estate investments, liquidity is an issue as it may not be possible to sell it at the right price when in urgent need of money.

Steady flow of income

An important lesson of the recent crisis is that a part of your portfolio should be devoted to steady income generating assets. A steady flow of income in the form of interest and dividends will help manage cash flow better, prevent distress sales and allow one to wait out periods of poor returns on one asset class.

(The author is a freelance writer.)

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