Diversification – the compelling case

By InCred December 10, 2020

At the time of writing this (early December 2020), markets almost everywhere are rising, hoping for an early availability of Covid-19 vaccine and continued access to easy money. The Dow is up, so is the Nifty. At such times, optimism prevails, and the positive sentiments overshadow negative sentiments. Now contrast this with just a few months back in March and April 2020 when the markets had tanked amid the pandemic-induced uncertainty. Back then fear and complete gloom had descended on the markets.

Anyone who has been invested in the Equity markets understands that volatility and fluctuations are in the very nature of markets.

The only way to not lose sleep over that which is inevitable, is to have a proper DIVERSIFICATION strategy in place. Diversification across assets, sectors and countries is a time-tested method for portfolio construction and is a must for wealth preservation. It helps one’s portfolio tide through the economic, political, financial and any other uncertainties, like the recent Covid-19 pandemic.

Low or Negative co-relation is the key

Diversification is holding investments which react differently to market or economic events. Negative correlation, simplistically speaking, can be defined by opposing moves in the prices of two assets classes at any point in time. When one falls, other rises up, thus preventing a big drawdown in the portfolio.

Typically, when the economy is in the growth phase, Equities tend to outperform Bonds. However, when conditions tighten, Bonds outperform Equities. By holding both, and other such inversely co-related asset-classes one can be assured of a minimum yield from portfolio, no matter the events around us.

There is a negative correlation between two asset classes.

Below is an example of few asset sets correlations over last 17 years. There is strong negative correlation between US Equities and Bonds, and it can be explained by the fact that US Treasuries are considered absolutely risk-free investments, and when equity markets fall, investors flock to US Treasuries. Though at a less pronounced level similar negative correlation exists between Nifty and India Composite Bond Index (maintained by CRISIL) too.

The extent of lower negative correlation in case of India can be explained by the fact that India, as an emerging market, is treated differently compared to developed markets.

Another interesting mildly negative correlation to note here is between Equities and Gold and hence gold also makes a good diversification asset.

Another interesting mildly negative correlation to note here is between Equities and Gold and hence gold also makes a good diversification asset.

There are multiple ways to achieve diversification:

Asset class diversification : Which implies diversifying across equities, debt and commodities. There is a strong case of negative or zero correlation amongst these asset classes (as discussed above), which support the portfolio at the time of worst drawdowns.

Country diversification :Given the exposure, diversification and upside potential arising from buying into global companies with innovative business models, we always recommend investing a portion in international equities. Depreciation bias in INR also helps this cause.

Sector diversification :It is always good to spread your portfolio across sectors and cyclicals. Investing in defensive sectors can help managing drawdowns in worst of the times.

Duration diversification :An often ignored area, but it is also important to look at your portfolio from the perspective of duration/maturities keeping in mind when your major future financial needs will arise.

Additionally, it is always a good idea to keep a part of your invested assets in cash or short-term money market securities. In case of an emergency, cash comes handy, and short-term money market securities can be liquidated instantly in case an investment opportunity arises. It is worth remembering, too, that asset allocation and diversification are interlinked; a diversified portfolio is formed through the process of asset allocation.

While stocks and bonds traditionally represent the tools for constructing a portfolio, there are other alternative investments to provide the opportunity for further diversification. Real estate investment trusts, hedge funds, art, precious metals, and other investments provide the opportunity to invest in markets that do not necessarily move in tandem with traditional financial markets.

The Bottom Line

Regardless of one’s means or methods, it is worth remembering that there is no single diversification model that meets the needs of every investor. Time horizon, investment purpose, risk tolerance, financial means, and investment experience all play a role in dictating one’s investment mix. It is always recommended to take guidance from an expert who will also continue to monitor and review your portfolio with you.

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