All of us must have heard the saying – don’t put all your eggs in one basket. This wise thought applies to financial investments too! In recent times, we have witnessed great market rallies that scripted a rag to riches story for many investors. In the quest for higher returns, we tend to underestimate our risk-taking ability and open ourselves up to the risk of losing everything that we have. Diversification of investments i.e. investing in instruments across asset classes and sectors has been proven an effective way of lowering risk. Portfolio management is the most common way of achieving diversification targets while ensuring that returns do not go down to a point where investing becomes financially non viable. In this article, we explore the need for diversification, the means to do it, and its effects.
What is diversification?
Diversification refers to the process of allocating investments into different asset classes like stocks, bonds, gold, commodities, real estate, etc. It also refers to investing in different sectors and subclasses within a class. For ex. In a stock - oriented portfolio, an investor should invest in different sectors like pharmaceuticals, energy, IT, etc. to mitigate risk. Within bonds, an investor can diversify among high-risk corporate bonds, gold bonds, low-risk corporate bonds, etc.
Why is diversification important?
It is important to not be too heavily invested in a particular area while leaving out others. This opens up an investor to a considerable amount of risk when the investment fails. Most investors are risk-averse, meaning that they seek higher returns for lower risks. They try to strike a balance between the two depending on their personal risk-taking ability. If the stock market experiences a crash, investments in Treasury Bills1 or government bonds act as a safeguard. In case there is a slump in the power sector, a well-diversified portfolio will enable an investor to earn from other sectors that he/she has invested in. However, if all investments were made in the power sector, he/she would experience a massive loss. Thus, it is important to invest across domains and mitigate your risk.
What is a portfolio and how do we determine a good one?
A portfolio refers to an individual/firm’s total investments taken together as a whole. A good portfolio is one that caters to the required return while ensuring that the risk involved is according to the individual/firm’s risk aversion and can vary according to needs. A portfolio that may be good for a hedge fund2,may not be good for a senior citizen. A portfolio also caters to the cash flow needs of the investor.
For example, a senior citizen may invest to earn a fixed income every month whereas a PE firm would look for capital appreciation in their investments. It also depends on the time that the investor is ready to commit his/her money for. A publicly-traded stock has high liquidity and the investment can be liquidated quickly if there is an urgent need for money. However, investing in a VC4 firm may need a lock-in period of 10 years, during which you won’t be able to get your money back. A good portfolio is also one that is well diversified and includes assets that have a low correlation between them.
Correlations between assets:
Correlation refers to the tendency of assets to move together. For example, Apple and Google stocks have a strong positive correlation between them due to the fact that they are both in the American technology industry and tend to have a lot of overlapping work.
However, energy stocks may not be well correlated with healthcare stocks. A positive correlation means that both assets move together i.e. if one goes up, the other goes up too. A negative correlation, however, means that if one of them goes up, the other goes down, thereby, mitigating risk. Government bonds and Treasury Bills are supposed to be risk – free assets and are assumed to have a zero correlation with other instruments. Insurance instruments have a negative correlation with the other major asset classes since they cover when the related investment crashes. Gold also has a negative correlation with stocks. Investors often include gold and other commodities in their portfolios as a way of reducing their overall portfolio risk. Gold also provides safety against geopolitical tensions.
Diversification among countries:
Many investors invest in emerging markets like India as they anticipate higher returns but they also incur a higher risk by doing so. However, currency returns are uncorrelated to stock returns that may help to cut down the risk of investing in otherwise risky emerging markets.
Diversifying with index funds and mutual funds to reduce cost:
Diversifying among asset classes can become costly for small portfolios because of the number of securities required. Ex. Creating exposure to a single class like domestic large companies may need a group of 30 such stocks. 10 such classes will need 300 stocks. Instead, it may be effective to use ETFs5 or Mutual Funds6 for this purpose.
Conclusion:
Developing a well-diversified portfolio can be a tough challenge and a financial advisor can help in creating a personalized portfolio. Otherwise, investors may use instruments such as Mutual Funds that invest in different asset classes to reduce exposure and are managed by expert fund managers. Putting all your eggs in one basket and betting on it can be a risky move and is not strategically sound. It is better to hedge against risk while maintaining returns and devise a portfolio that caters to your fixed-income needs and timeline of investment.
Glossary:
Treasury Bills: A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less. Treasury bills are usually sold in denominations of $1,000.
Hedge Funds: Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors. These funds may be managed aggressively or make use of derivatives and leverage to generate higher returns.
Liquidity: Liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. Cash is universally considered the most liquid asset because it can most quickly and easily be converted into other assets.
VC: Venture Capital(VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks and any other financial institutions.
ETF: An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur.
Mutual Fund: A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt.
Akarsh is a data science, finance and writing enthusiast currently studying as an undergraduate at IIT Delhi. He closely tracks the financial markets and economic policies of the government.
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