Primary goal of the diversification concept is to limit the impact of volatility in the portfolio over time. One way to balance risk and reward in your investment portfolio is to diversify your assets. Investments are held across multiple uncorrelated asset classes, then the portfolio is genuinely diversified and better able to handle market volatility, as the high-performing asset classes can balance out the underperforming classes. The problem is that a lot of people don’t understand the concept of diversification accurately. People think that diversification means buying several assets. Due to lack of knowledge people will select the plans which do the same things under different names.
For example, a person diversified their portfolio in mutual funds which includes an UTI small cap fund, L&T emerging business fund, Nippon India multi cap and Kotak emerging equity, it did not truly fulfil the portfolio with diversification strategy. Because the portfolio has major exposure in the small and mid-cap sector. Small-cap stocks are more at-risk during downturns, as the early months of the coronavirus pandemic demonstrated. During the crisis, small-cap stocks underperformed their large-cap peers by a significant margin. You should not put your entire money into a single asset class because your attached goals might get seriously impacted if that asset underperforms, also it should match with the time period of your goal and risk appetite.
Components of a diversified portfolio
Here, we will discuss how to achieve true diversification through asset class selection.
Basic asset classes are Equity, debt /fixed income, cash equivalents (hold some amount for taking advantage of opportunities in other assets). In addition to this Short-term investments, Sector funds, Commodities, Real estate.
In the comprehensive financial planning portfolio, people need to have a healthy distribution of assets, like the following,
Equity – Direct Equity and MFs Equity
Fixed income plans with short and medium duration – FD, RD, Postal Deposits, and Tax-Free Bonds.
Fixed income plans with long term duration – EPF, PPF, NPS, Bonds
Other – gold (SGB) etc.
International Diversification
Most people in India do not have US investments. The Indian mutual funds like Motilal Nasdaq 100 offer US portfolios. It is an opportunity for Investors to participate in strong companies like Amazon, Facebook, Google through these mutual funds. Investors can diversify their portfolio globally and can take advantage of this developed country’s economic growth.
How will diversification work for you?
high correlation exists between the return’s investors achieve on their holdings and the underlying asset class performance of those holdings. Make a portfolio effectively through selecting and holding a variety of asset classes. Ideal asset allocation is not fixed, it needs to be changed depending on changes of the asset’s performance and their correlations to each other, so monitoring and rebalancing are crucial factors. But many investors divest only the underperforming assets, move the investment to asset classes generating better returns, but before doing that, understanding the factors which influence the performance is necessary. Sometimes, an extended bull market can lead to overweighting in an asset class that may be due for a correction. Investors should rebalance their asset allocation at both ends of the performance scale. This way asset allocation will help you on long term performance and short-term volatility.
Let’s take an example of the most aggressive diversified portfolio which comprises 75%equity, and 15% debt, 10% Others (like Gold, Real estate). Approximately, its best 12-month return was more than 50%, while its worst 12-month return would have been more than -30%. That’s probably too much volatility due to the recent Covid crisis. Unfortunately, many conservative investors overlook the risk element in equity products, when these products offer huge returns. As we can see the index fund offers negative returns of more than 30% during March 2020. The trouble with these assets is that they hurt the most when things start going wrong in the market. As long as the markets are good, equity continues to make higher returns. But in the case of a market collapse, the conservative assets like FD, Bonds will help to average portfolio returns. For example, long term goals like retirement planning, equity investments in combination with long term plans like EPF, PPF, NPS will serve you better.
Conclusion
Right now, everybody keeps suggesting a diversified portfolio with large, mid and small categories of mutual funds in a very simple manner, but it does not fulfil the diversification strategy completely. If you want to diversify your portfolio to minimize volatility and effective returns, you should carefully assess the different asset classes. You need to respond according to the economy, to the markets and to a lot of things. The diversification concept is to avoid overlaps between the same category of asset classes, it is a good way to participate in various segments of the market at various points of time. It is not about putting money randomly in the market. It’s all about the strategies which are used to reduce the impact of volatility.
