What do we understand by a diversified portfolio and how to diversify portfolio. The whole logic of diversification is to reduce your risk. If all your assets are going to move in the same direction then it means all your assets will give negative returns when the cycle turns down. For example, if you are heavily invested in metal stocks and if the global metal cycle goes into downturn then your entire portfolio will underperform. By combining different assets that are not exactly correlated you will get the benefit of reduced risk. Let us consider with a simple diversified portfolio example of just two assets that are negatively correlated. That mean when one asset gives higher returns the other asset gives lower returns. You can depict this diversification relationship as under..
In the above example when Asset Class A gives higher returns, the Asset Class B gives lower returns and vice versa. As a result the average returns keep going up over a period of time. That is called the combination of an umbrella asset and a sunscreen asset. This benefit arises when A & B are combined into a single portfolio.
What is the logic behind diversification?
Diversification works because there are two types of risk. The unsystematic risk is unique to assets or sectors or specific themes. This can be reduced to near zero by combining other assets with negative or low correlations. These are risks like rising interest rates, rising bond yields, industrial unrest in a particular industry or company, downsides in the commodity cycle etc. Systematic risk, on the other hand, impacts all asset classes. Political uncertainty, fall in GDP growth or global geopolitical risk are negative factors for all asset classes.
There are 3 key inferences that one can draw from the above chart. Firstly, it is only unsystematic risk that can be diversified. Systematic risk remains constant even if you diversify across asset classes. Secondly, even unsystematic risk cannot be reduced to zero because some element of unsystematic risk still remains in your portfolio even after you diversify. The unsystematic risk can only be substantially reduced. Lastly, adding more assets only works up to a point. Beyond that point it only leads to substitution of risk and hence unsystematic risk also remains constant after a point.
How to go about the process of diversification..
Here is a logical process that you can follow to diversify you risk in the portfolio..
Diversify among asset classes
The first step is to diversify across asset classes. That is why you need to combine equities, debt, hybrid asset classes, ETFs, index funds, gold, property, foreign assets etc. This ensures that your overall risk is spread out across more asset classes and your overall portfolio risk is reduced. The process of diversification begins with identifying the different asset classes that you want your portfolio to be exposed to.
Diversify within debt based on quality
Once you have identified debt as an asset class and outlined the total exposure to debt, the next step is to diversify within debt on the basis of asset quality. You need to decide how much should be invested in risk-free government securities and how much in state government securities. Then you come to corporate debt. You need to take a call on how much should be invested in corporate debt with AAA rating and how much to be invested in corporate debt with AA rating. Ideally, you should not go below AA as it entails higher default risk even though it also gives higher returns.
Diversify within debt based on duration
What do we understand by diversifying debt based on duration? There is a simple explanation based on your liquidity needs. Accordingly, your portfolio should be divided between liquid funds and debt funds. Within debt funds how much should be in duration above 5 years and duration below 5 years. That will depend on your outlook on interest rates. Normally, long maturity bonds react more negatively to rising bond yields and that will determine your diversification mix.
Diversify within equity by Sectors
Sectors refer to industrial groups like capital goods, consumer goods, pharmaceuticals, Information technology etc. Each of these sectors depends on unique features. For example cement and steel benefit when the construction cycle picks up. Banks and financial stocks benefit when the rates in the economy go down. Oil and Steel benefit when the commodity cycle turns upwards. You need to diversify your risk with a judicious mix of these sectors in the right proportion.
Diversify within equity by themes
How are themes different from sectors. Actually, themes can cover a number of sectors. For example let us look at rate sensitivity. Sectors like banking, NBFCs, automobiles and real estate benefit when the interest rate are headed down. If you are diversifying by theme ensure that you are not overexposed to a theme. Similarly if you take rural demand as a theme then higher rural incomes benefits tractors, two wheelers, FMCG products, agro chemicals, fertilizers and hybrid seeds etc. You need to build your diversification plan accordingly.
Diversify by companies
Finally, you also need to diversify within companies based on a variety of themes. Let us look at a few of them. You need to combine companies with higher operating margins with companies that have high asset turnover ratios. Similarly, you need to combine high growth stocks with high dividend yield stocks. This combination will ensure that the net outcome is positive.
Diversification forms one of the basic pillars of investing and is the simplest and most rudimentary methods of reducing risk. That is where portfolio creation begins!