For meeting long-term goals, the role of equities is well recognized among the investor community globally. Several studies done in the past have shown that equities as an asset class have the potential to deliver high inflation-adjusted return compared to other assets.
While the inherent nature of equities is to remain volatile in short-to-medium term, in the long term, the equity asset values tend to drift upwards.
And, even as you start saving through equities, there are ways and means to bring down the volatility and the risks associated with investing in equities.
One of those tools or a strategy to manage equity risk is diversification. But, merely diversifying within the same economy is not enough. Once you have built a portfolio with Indian stocks, allocating some portion into international stocks provides the necessary diversification to your portfolio. “Diversification across geographies or asset classes is the best way for portfolio construction. A lot of investors think that by having a large, mid and small cap fund they are diversified. But the reality is not so,” says Pratik Oswal, Head of Passive Funds, Motilal Oswal Asset Management Company.
The US stock market provides an opportunity to Indian investors to diversify abroad and bring in the necessary diversification to the domestic portfolio. The US stock market provides the biggest opportunity to Indian investors to diversify their domestic portfolio among some of the leading global technology, Internet, Pharma and manufacturing companies amongst others.
If you are a mutual fund investor investing across various sectors and market-capitalisation in the Indian scenario, your portfolio is not yet adequately diversified. “Almost all equity funds in India are highly correlated (90 per cent+) offering little diversification. An example of this was March 2020 – every equity fund was down 40/50 per cent,” says Oswal.
A strong reason for diversification is the correlation that exists between the Indian and US stock market. “The S&P500 or the NASDAQ 100 index has a 30-40% correlation with India. When Indian markets don’t perform – international stocks offer downside protection and vice versa,” says Oswal. The lower the correlation, higher is the diversification providing stability in a portfolio.
Investing solely in one economy keeps them exposed to country-risk. There are several micro and macro economic Geo-political factors that impact a nation’s economy. In case of any internal economic and political conflicts within the country, the portfolio remains exposed to the concentrated risk. The best part of diversifying across boundaries is to avoid any bad surprises as far the economic situation of a single economy is concerned. While both, Indian and US economies have a strong future ahead, diversifying helps in keeping risks in control.
“The only way to diversify is to invest across asset classes like gold, debt and international equity. Unlike Gold and debt where investors will sacrifice returns for lower risk – international equity has delivered excellent returns while resulting in a lower portfolio risk,” adds Oswal. In order to minimize risk and maximize the potential of returns, you need to diversify your investment portfolio. Diversification across asset-class, market capitalization etc is incomplete unless you diversify geographically.