NEW DELHI: Benjamin Graham, regarded as the guru of ace investor Warren Buffet, once said diversification is an established tenet of conservative investment.
Graham said there remains a logical connection between the concept of a safety margin and the principle of diversification. Ask any fund manager, that view would still find support, even though the financial markets as a whole and their functioning have taken a big leap over the past half-a-century.
Think of the days when events unfolded around Brexit. No, yes, no... and on June 24, the Black Swan event triggered a bloodbath on Dalal Street and unmanageable volatility in bond and commodity markets.
Now recall August 2015, when a series of yuan devaluations by Chinese central bank PBoC rattled financial markets globally. These developments made emerging market currencies, including the rupee, take a beating. There was risk-off trade and money was moving to safe haven like gold.
Remember, gold has underperformed other asset classes since it peaked in 2013. If you had a mix of gold and equities, you would not have had sleepless nights during this period. Would you?
What is it?
Simply put, diversification is a way of investing wherein investors buy negatively-correlated assets.
Diversification could be as simple as choosing to invest in equities, bonds, real estate and gold through various schemes such as mutual funds or REITs or as complex as exotic assets such as timberland or antiques in one's portfolio.
Diversification can also be made within one asset class. For example, one can take adequate exposure in both midcap and smallcap stocks, rather than sticking to only midcap and smallcap names. One can also diversify a portfolio between various countries -- buying government bonds of one country and equity shares in another or any other such combination aimed at achieving stable long-term returns with less volatility.
What does it achieve: Peace of mind
Jayant R Pai, Head of Marketing at PPFAS Mutual Fund, said diversification is a must for lay investors as they usually cannot devote much time and effort to make a concentrated bet.
"Every asset class has a different return-risk profile and combining various assets judiciously can help reduce portfolio volatility. Diversification is the only way to eschew angst and enhance one's peace of mind. It is also an implicit admission that one is not omniscient. This awareness is useful in itself," Pai said.
In an inflationary environment like what India experienced during 2010-12, 'real' assets like gold and real estate provided some respite, compared with equities and bonds. There was no specific event and the trigger was protracted.
Specific events such as the precipitous fall in oil prices from August 2014 onwards propelled the stocks of oil-consuming nations to new highs, while prices of gold and commodities tumbled.
Investors, who had diversified their portfolios, emerged net winners, Pai said.
"You can't keep pace with inflation by just investing in fixed income assets. Equity investments generate higher returns over the long term, albeit with some volatility. At the same time, investing everything in equity is not advisable either. You need to set aside some allocation to liquid funds/bank deposits to meet sudden cash flow needs. Similarly, debt can give some stability and protect portfolio values in case of sharp volatility like the 2008 financial crisis," said Suresh Soni, CEO, DHFL Pramerica AMC.
Does it harm returns? Not really
Have a look at each asset class and you will find that the degree of risk differs from one asset to another. Equities, commodities and realty are riskier than bonds and bank fixed deposits (FDs), which are more or less risk free. The more the risk, the more is the potential for return or loss. But that does not always hold true.
Equity-oriented diversified mutual funds, which also invest in debt instruments, have delivered 11.5 per cent returns annually in last 10 years. Debt-oriented funds, which also invest in equities, have offered 9.5 per cent return annually during the same period. The equity benchmark BSE Sensex has, on the other hand, offered a return of 9.4 per cent during the same period.
The risk associated with equities is high, but adding debt instruments can make the portfolio less risky, without compromising on stable returns.
What big global billion-dollar funds do?
Big sovereign funds believe in diversification.
Norway's Government Pension Fund - Global, which manages $900 billion, had 59.6 per cent of its assets in equities, 37.4 per cent in fixed income products and 3.1 per cent in real estate investments as of June 30.
Dubai's Abu Dhabi Investment Authority (ADIA), which manages about $800 billion, keeps 10-20 per cent of its corpus in government bonds, 42-62 per cent in developed and emerging market equities, 5-10 per cent in real estate, 2-8 per cent in private equity and 5-10 per cent in alternative assets.
China's China Investment Corporation, which managed over $810 billion at the end of 2015, had equities accounting for 47.47 per cent of its portfolio, while fixed income assets accounted for 14.44 per cent of the portfolio at the end of 2015, the fund said in July.
What should a middle-class Indian do?
Funds keep a balanced approach to investing. As seen above, while big funds invest more in equities, they have sizable interest in fixed income products as well. Add gold and real estate to your portfolio and it would be more diversified and less risky.
"Looking at the current scenario, a moderate risk-taking investor should have 35-40 per cent of his assets in domestic equities, another 35 per cent in fixed income products, about 10-15 per cent in international equities and the balance in gold," said Ashish Sommaiyaa, Managing Director & CEO at Motilal Oswal Asset Management.
"The economy is turning around; the worst is over and we would see good earnings revival over the next few quarters. Reforms and investments are gathering pace and the macro factors have improved. Hence, we are bullish on equities. Gold is negatively correlated with equities. So, a small investment in gold is always welcome," Sommaiyaa said.
"Geopolitical tensions remain high and escalating currency wars have added more uncertainty. Given the macroeconomic picture, gold will be a useful portfolio diversification tool, thereby, helping investors to reduce the overall portfolio risk," Quantum Gold Fund said in a recent note.
Experts say real estate can be a part of a portfolio but there is no financial vehicle for it. For a middle-class investor, a physical investment in real estate and the resultant monthly installments can take away a bigger chunk of the investible money. Thus, creating a diversified portfolio, after buying a property, can become a challenge.
The original article could be seen here.