They say, ‘don’t put all your eggs in one basket’. This concept of avoiding concentration risk holds true in the world of investing as well. Economic cycles, geopolitical shifts, regulatory changes, or unforeseen events could impact financial markets. Thus, by diversifying a portfolio across diverse investments, sectors, investment styles, geographies, and asset classes, investors can safeguard their portfolios against these uncertainties and volatilities. Nobel Laureate Harry Markowitz introduced the Modern Portfolio Theory in the 1950s, which demonstrated how a well-diversified portfolio can reduce risk without significant compromise on potential returns.

Let’s look at some of the ways investors can build a well-diversified portfolio. But before that, the initial step for every investor must involve understanding their investment goals, risk-return expectations, time horizon, liquidity requirements. This process, referred to as investment objectives setting, forms the bedrock of portfolio construction. The exercise facilitates the identification of an appropriate asset allocation that ideally aligns with the investor’s profile.

Once the investor profile is in place, the next step involves determining the optimal mix of asset classes. The traditional asset classes comprise equities, bonds, and cash. Nevertheless, it’s essential to consider non-traditional investments such as private equity (PE), venture capital (VC), venture debt, structured credit, real estate, commodities, and the like, depending on investor suitability. Equities offer the potential of substantial investment growth, but they also entail heightened risk due to market fluctuations. Bonds, by contrast, pose relatively lower risk, thereby ensuring stable returns and a regular income stream. Funds required for immediate liquidity needs should be held in cash or equivalent instruments.

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Non-traditional assets like PE and VC, also called as private markets, exhibit lower correlation with conventional asset classes and elevated return potential. However, they also come with escalated risk and are illiquid. Venture debt and structured credit are relatively newer asset classes in India but have emerged as good alternatives to fixed income allocation. They can enhance returns but also come with higher risk. Real estate presents the possibility of both income generation and capital appreciation. Investors can access real estate either directly, through funds, or even via real estate investment trusts (REITs).

Amongst commodities, gold is a highly favoured asset class, particularly in India. Gold tends to display a somewhat negative correlation with equities, thereby can act as a hedge against volatility.

Diversification within an asset class is equally important. For example, within equities investors can diversify across large cap, mid cap and small cap companies. They can further spread their investments across different sectors and industries. Finally, an aspect that is often missed is diversification in terms of investment styles, growth-oriented vs value-oriented approaches, active vs passive investments. Similarly, within fixed income, private markets and other alternative asset classes there exists scope to diversify.

Most investors, especially in India, have a strong home country bias, i.e., large part of their portfolio is invested in Indian markets only. This exposes the portfolio to country-specific events like major political shifts or regulatory alterations. Investing in internationally, whether through equities or bonds, can serve as a means to gain exposure to diverse economies and currencies, thereby mitigating these risks. Furthermore, the economic cycles of different economies often diverge, potentially creating opportunities to generate alpha for the portfolio. Additionally, certain sectors may flourish more in specific countries — take, for instance, AI and technology in the US, or semiconductors in Taiwan.

The final stage diversifying at the instrument or security level. When investing in direct stocks investors will need to diversify across few stocks, similarly while investing in direct bonds investors need to diversify. However, it’s worth noting that mutual funds and ETFs inherently offer diversification. The presence of multiple ETFs that follow the same index is faux diversification. Likewise, possessing several mutual funds of the same investment style might not yield significant additional benefits.

One a well-diversified portfolio is created it requires periodic adjustments in response to market conditions. Additionally, regular rebalancing is also crucial. Over time, a portfolio’s asset allocation might drift from the initial plan due to variations in the performance of individual asset classes. This divergence could result in portfolio skewing to one specific asset class, potentially altering the risk-reward dynamics of the portfolio. Regularly rebalancing brings your allocation back to its intended mix and also naturally entails selling assets that have experienced significant growth and might be relatively expensive, while acquiring assets that have underperformed and might be comparatively undervalued.

It’s important to recognize that all investments entail some degree of risk. Constructing a diversified portfolio doesn’t eradicate risk; rather, it spreads risk across diverse assets and investments.

(By Roopali Prabhu, Head of Products and Solutions, Sanctum Wealth.)

Disclaimer: This is the author’s personal opinion. Readers are advised to consult their financial planner before making any investment.