Protecting returns: Do’s and don’ts of portfolio diversification

Published: June 19, 2020 2:50 AM

The decision to diversify or not should be driven by your investment goals, risk profile and the size of your investments.

Remember, this diversification works only if the asset classes in question are not positively correlated.Remember, this diversification works only if the asset classes in question are not positively correlated.

By Hemanth Gorur

In the investment world, high returns are almost always accompanied by high risk. So, what if you want to protect your returns but minimise your risks? This question dogs every investor, small or big.

Diversification is an investment strategy used to spread the risks across various investments or assets. On an upswing, potential returns are definitely lower than if you do not diversify. However, when the chips are down, your investments will be protected from higher losses.

Portfolio-level and asset-level diversification
Most diversification by retail investors is done at the portfolio level, wherein investments are made in different asset classes to lower overall portfolio risk. This is portfolio-level diversification. Remember, this diversification works only if the asset classes in question are not positively correlated.

For instance, equity and gold are not correlated. That is, the economic forces affecting these two asset classes do not push their respective prices in the same direction or by the same magnitude. In fact, they move in opposite directions.

Within each asset class too, diversification can be achieved to take advantage of certain characteristics of the asset subclasses. This is asset-level diversification.

For instance, within equity, you can diversify between large cap and small cap stocks. Large caps are known for long term wealth creation while small caps can be invested in if you need quick returns but are riskier. Within “risk-free” investments, government bonds are far safer than even bank deposits.

When exactly to diversify
The decision to diversify or not should be primarily driven by your investment goals and your risk profile or risk propensity. The third factor driving this decision is the size of your investments.

First, consider your investment goals. If you have multiple goals, you are more likely to choose a larger number of asset classes or subclasses to invest in. This has to do with the risk-return profile and maturity periods of various asset classes. Next, consider your risk profile or propensity to take risk. If you have lower risk propensity, ie., you have very low tolerance for investment risk, then you are highly likely to increase your diversification at the cost of upside potential for higher returns.

Lastly, consider your investment ticket size. Larger ticket size naturally demands a greater variety of asset classes to choose from, for it is impractical and inefficient, not to mention highly risky, to park huge lump sums in just one or two asset classes.

When should you not diversify
Now let us come to when you should avoid diversification. It’s a common myth that diversification is always good. In certain cases, you are better off not diversifying. Let us say you have multiple investment goals or preferences – monthly liquidity, long term wealth creation at moderate risk, and long term security. Also let us say your investment ticket size is large. Individually taken, the nature of your investment goals and your investment ticket size would dictate diversification into multiple asset classes.

However, consider buying a large villa property and letting it out for rent. Not only did your investment objectives get met, but also you did not need to resort to diversification for that. Low diversification has its own advantages, prime among them being lesser overhead costs and time in managing your investments.

In sum, it boils down to the combination of the three factors mentioned earlier and the investment options at hand. When you decide to diversify, make sure you are doing so for the right reasons.However, know that not diversifying is also an option in certain investment scenarios.

The writer is co-founder, Hermoneytalks.com

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