By Varun Fatehpuria
Diversification has often been called the only free lunch in investing. In simpler terms, diversification is the investing strategy of allocating your money across different asset classes to reduce the overall portfolio risk. A well-diversified portfolio ensures that your investments can perform in varied market conditions and not be affected by any single event.
As Harry Markowitz established in his Nobel Prize-winning research in 1952, a portfolio’s overall risk is determined not just by the sum of its components but also by its correlation, or how individual holdings interact with each other. Constructing a portfolio with investments that have correlations below one can reduce the overall portfolio’s risk profile. The lower the correlation, the greater the reduction in volatility from adding additional investments.
What diversification is not
A lot of people have wrong and misconceived notions about diversification. Now that we have established what it is, let us more importantly see what it is not:
A strategy to maximise returns: Diversification is by no means a guaranteed way to earn positive returns in the equity markets. It only helps in reducing the overall risk profile of the portfolio.
Collecting a bunch of similar behaving investments: People often conflate the number of investments in their portfolio with diversification. Adding more of similar investments is not diversification. One must add asset classes, i.e., debt, equities, gold, etc., that behave differently in a given market condition.
Components of a diversified portfolio
Here are the four basic components of a diversified portfolio:
Cash/money-market investments: These include money-market funds that are ideal for those who are looking to preserve the value of their investments. They offer stability, liquidity and easy access to your money. However, that also comes with a drag on the returns vis-a-vis other bond funds or individual bonds.
Fixed income / bonds / debt: Fixed income instruments provide regular income and capital protection. They also often act as a cushion against the unpredictable ups and downs of the equity markets. This is a low-risk asset class, but instruments such as debt mutual funds, company FDs, and debentures are often subject to credit and interest rate risk depending on the instrument or the scheme.
Domestic equity: Domestic equities are supposed to be the bedrock of your equity investment portfolio. While the allocation of equities in the overall portfolio will ultimately depend on your individual risk-tolerance level, any equity exposure is important to deliver long-term, inflation-beating returns. A well-diversified portfolio is invested across market capitalisations, i.e., large-cap, mid-cap, small-cap; geographies, i.e., India, US, Europe; and style of investing, i.e., value and growth.
International equity: US/European stocks often behave differently than their Indian counterparts, providing exposure to opportunities not offered by Indian securities. Investors should consider carving a certain portion of their portfolio for international stocks that offer higher potential returns but come with higher risk.
A well-diversified portfolio will provide you with a smoother investment journey and help you better manage the ups and downs of the market.
* Allocate your money across different asset classes to reduce the overall portfolio risk
* Lower the correlation between assets in your portfolio, greater the reduction in volatility
The writer is founder and CEO, Daulat