Why you should have a diversified portfolio?

The bad experience of equity investment last year has one silver lining. It taught us the importance of diversification and the right asset allocation. Your equity portfolio would definitely have been in negative last year. In the last one year performance of all the categories of equity are in negative except for large-cap category. There were some thematic and sectoral funds that too gave positive returns. Nevertheless, in case of debt funds, not a single category gave a negative return. This is despite the debt market going through its own source of turbulence due to corporate governance and default with some of the corporates. Among debt fund, gilt funds generated a maximum return of 8.76 per cent in last one year. The lowest return among the debt fund was generated by ‘credit risk’ fund of 5.04 per cent.

Hence, if you had a portfolio of equity funds giving equal weight to large-cap, small-cap and mid-cap funds, your return in the last one year would have been negative 4.46 per cent. Nonetheless, if you would have invested 60 per cent of your portfolio in equity funds (equally in large, mid and small-cap funds) and 40 per cent in debt funds (equally in long, medium and short duration funds) your overall portfolio returns would have been positive at 0.05 per cent. Although it looks lower, it is better than negative returns.

It may happen that in the next year equity will hugely outperform the market and this diversification may pull your returns down. It was the case in the year 2008 and 2009. Diversification would have helped your portfolio in the year 2008 to generate better returns, however in the year 2009 when markets recovered they would have acted as a drag for your portfolio. The only problem with such an argument is that they work only in hindsight. Nobody would have waited till the end of 2008 or till the start of 2009 with their equity portfolio only to see its value declining every day. Most of the investors are risk aversive, want to protect their capital and would have sold before the market recovered.

Therefore, depending upon your risk appetite and financial goal, you can have an appropriate asset allocation. In addition to equity and debt, you can also include commodities such as gold to diversify your portfolio. The selection of assets should be such that they exhibit a lower correlation of returns.