Diversification and the investment trinity: Keys to a healthy portfolio

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Diversification and the investment trinity: Keys to a healthy portfolio

Authored by Shiv Gupta, Founder & CEO, Sanctum Wealth

Many well-known investors like Warren Buffet, who famously said that diversification is a protection against ignorance, espouse the virtues of concentrated portfolios for wealth creation. Indeed, many of us could replicate their successes if we had their analytical skills, long time horizons, the ability to accept mistakes and course-correct, and the equanimity to stay put through extreme market movements.

However, the truth is that most investors do not possess all these virtues, and a more effective way to successful wealth creation is to follow the principles of asset allocation and diversification.

Probability and psychology

Investing has some interesting characteristics.

It is a game of probability with no certain outcomes. Hence, an investor’s goal is to increase the odds by making sensible choices in creating and managing one’s portfolio. A long time horizon is one such choice.

There is no one-size-fits-all approach to investing, and everyone has a different profile based on one’s goals, experience, and psychology.

Asset prices, particularly equities, do not move in an orderly manner and extreme movements do take place. For example, for the period from early 2008 to early 2012 the Nifty 50 index was flat but during this time it fell as much as 58 per cent and then rose 145 per cent. Plus, markets are noisy. These gyrations and the accompanying cacophony could make even the most resilient investor lose her nerve. Hence, many wise practitioners characterize successful investing as a journey of managing one’s psychology.

The investment trinity

Given these characteristics, a lot can go wrong. Fortunately, financial theory does have tools that can help investors manage problems that typically arise. These are effective profiling, asset allocation, and diversification.

Profiling is a diagnostic exercise that involves identifying the risk-return parameters for managing one’s portfolio by setting clear and realistic goals, accounting for time-related constraints, and understanding one’s psychology as it relates to investing. If done well, it can significantly improve an investor’s ability to stay the course and avoid making rash decisions amidst extreme market movements.

Then comes asset allocation. It involves dividing a portfolio’s assets in line with an individuals’ risk-reward profile e.g., 40 per cent equities, 40 per cent fixed income, and 20 per cent alternatives. This is known as strategic asset allocation and is the first and most important step in diversification. The table below provides a glimpse of the risk-reward characteristics of various combinations.

Portfolio mix Average annual return (per cent) Best year (per cent) Worst year (per cent) Years with negative returns
100 per cent bonds 7.1 14.3 -0.3 1 out of 19
80 per cent bonds and 20 per cent equity 10 21.8 -3 1 out of 19
60 per cent bonds and 40 per cent equity 12.9 35.5 -15.1 2 out of 19
40 per cent bonds and 60 per cent equity 15.8 49.2 -27.1 2 out of 19
20 per cent bonds and 80 per cent equity 18.7 62.9 -39.2 3 out of 19
100 per cent equity 21.6 77.6 -51.3 3 out of 19

*Equity returns based on S&P Nifty 50 TRI returns; bond returns based on CRISIL Composite Bond Fund Index

The next step is to diversify across instruments based on a range of parameters. These include geographies, market capitalizations, sectors, themes, investment styles, issuer types, credit quality, duration, and payoff profiles. This is to spread the risk across investments with differing degrees of co-movement with each other, known as correlation. It also allows investors to take exposure to a wider array of strategies to benefit from different investment hypotheses.

The asset allocation quilt shown below is a popular illustration of how asset classes move at various times.

2017 2018 2019 2020 2021
Equities (30.3%) Gold (6.9%) Int'l Equities (26.8%) Gold (26.2%) Equities (25.6%)
Int'l Equities (14.4%) Bonds (5.9%) Gold (22.9%) Int'l Equities (17%) Int'l Equities (18.8%)
Bonds (4.7%) Equities (4.6%) Equities (13.5%) Equities (16.1%) Bonds (3.4%)
Gold (2.9%) Int'l Equities (-2.8%) Bonds (10.7%) Bonds (12.3%) Gold (-4.8%)

*Asset classes returns mentioned above are derived from the benchmark as follows :

Equities - Nifty 50 TRI, International Equities - MSCI ASWI in INR, Gold - Gold Bees, Bonds - Crisil Composite Bond fund Index

The final step is to identify the number and types of instruments to buy. This is known as security selection. It includes choosing between individual securities, like stocks and bonds, and collective vehicles like mutual funds. For this there are thumb rules. For instance, 20-25 stocks weighted for market capitalization in an equity-only portfolio or 8-10 mutual funds for a balanced portfolio represent diversification in the Indian market. In selecting securities, investors should beware of overdiversification or “diworsification”. This is where the portfolio has too many securities, adding unnecessary complexity, or where the addition of securities with high correlations worsens the overall risk-reward characteristics of the portfolio.

A balancing act

Once constructed, the investor is largely set. However, the portfolio does need periodic maintenance. There could be reasons to make minor changes to the asset allocation based on nearer-term market views. The portfolio’s composition could also change through asset price movements without the investor taking any action. These events require adjustments known as tactical asset allocation and rebalancing. Further, investors’ profiles change over time with their ages and situations. Accordingly, they should review and recalibrate their strategic asset allocation periodically, too.

In practice, there is no magic formula for determining the correct diversification. Approaches vary from using sophisticated quantitative techniques to simply following a set of thumb rules. In either case, applying these principles requires a certain amount of knowledge and experience. Investors who do not have these should consult advisors with the wherewithal to guide them. For do-it-yourself investors, an increasing number of online tools for profiling, asset allocation, and portfolio construction, such as robo-advisors, are also becoming available.

In the end, a few simple techniques applied diligently, can make all the difference to the health of a portfolio. Leonardo Da Vinci introduced the world to the wonderful adage that simplicity is the ultimate sophistication. In the investing world, the concept of diversification comes closest to embodying this idea.

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