We tend to talk about diversification of risk, diversified portfolio, diversified mutual funds etc. But, what exactly is diversification as a concept and how and why does it actually work in practice?
What is meant by diversification?
So, what exactly is a diversified portfolio and how to diversify your equity or mutual fund portfolio? The logic of diversification is to reduce your risk by spreading across assets that do not behave in a similar manner. If all your assets or mutual funds in the portfolio 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 fully invested in metal sector funds, you are going to suffer when the global metal cycle goes into downturn.
Here is where diversification comes in handy. Let me give an example. If China slows down then Indian metal companies will suffer due to weak demand. However, chemicals will gain as it opens more opportunities for Indian business. So having an exposure to chemicals and metals can give you some amount of diversification of risk, especially against the China risk.
Diversification means combining different assets that are not exactly correlated. That is when 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.
Can you explain how diversification actually works in practice?
Diversification works in practice because there are two types of risk in the market. Firstly, there is the unsystematic risk which 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. Secondly, there are larger risks like rising interest rates, rising bond yields, inflation, weakening rupee, global oil price spike etc. These are all examples of Systematic risk, which cannot be diversified away, so you low correlation theory does not work here. Check the graphic below.
What do you really infer from the above chart. Let us look at 3 inferences
Firstly, only unsystematic risk can be diversified. Systematic risk remains constant even if you diversify across asset classes. You just need to managed the systematic risk in the portfolio.
Secondly, even unsystematic risk cannot be reduced to zero as you see the chart above running parallel to the base line. The unsystematic risk can only be substantially reduced and some surprises will still remain at a company or sectoral level.
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. Normally, a portfolio up to 12 or 13 stocks is good enough to diversify.
Can you tell me how to diversify across asset classes?
Actually, this is the first step in diversification. The first step is to diversify across asset classes. At this stage you just combine equities, debt, hybrid asset classes, ETFs, index funds, gold, property, foreign assets etc. This ensures that your overall risk gets meaningfully spread out across more asset classes and therefore overall portfolio risk is reduced.
How to diversify debt fund holdings on quality?
Debt funds will be part of any asset allocation although the quantum may differ. Once you have identified debt as an asset class and outlined the total exposure to debt, next step is to diversify within debt on the basis of asset quality. Quality of debt is based on ratings and normally higher the rating lower the yield and lower the rating, higher the yield. For most debt fund investors this is a trade-off.
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 must now take a call on how much to invest in corporate debt with AAA rating and how much to be invested in corporate debt with AA rating. Most fund managers do not go below investments in AA rated debt. Be wary of illiquid structures.
How to diversify debt funds based on duration?
What do we understand by diversifying debt based on duration? It is an extension of the maturity and you must decide whether you must hold long duration or short duration debt funds. There is a simple explanation based on your liquidity needs. Accordingly, your portfolio must 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 and how much should be in duration under 1 year. That will depend on your outlook on interest rates. Normally, long maturity bonds react negatively to rising bond yields and vice versa.
How to diversify equitiy portfolio on sectors and themes?
Let us look at sectors first. Sectors refer to industrial groupings like capital goods, consumer goods, pharmaceuticals, Information technology etc. For example cement and steel benefit when construction activity picks up. Banks and NBFC stocks benefit when rates in the economy go down. Oil and Steel benefit when the commodity cycle turns upwards. As a mutual fund investor, your equity portfolio must be diversified across such sectors.
How are themes different? Themes cover a combination of sectors. For example rate sensitive is a theme. 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 one particular theme. Similarly rural demand is a theme wherein higher rural incomes benefits tractors, two wheelers, FMCG products, Agro chemicals, fertilizers and hybrid seeds. Diversification is about a judicious mix of themes too.
Is it also necessary to diversify across companies or funds?
Yes, 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 must combine high growth stocks with high dividend yield stocks. You can also select the funds accordingly based on the theme or just focus on fund portfolios.
Is There a Quick Checklist that I can use for Diversification of Funds?
Here is a quick 7 point checklist for diversification of risk.
Put a limit on the number of unique assets to diversify across. Going beyond 8-10 funds will not help as each of the individual fund is also diversified. Till a point, there is incremental benefit in adding more, after that don’t keep adding assets.
Diversification is all about low correlation assets. If you are holding a stock and add another stock with a correlation of “1” with the previous stock then there is no diversification.
Diversification across sectors and themes normally tends to work quite well. A better choice than combining sector funds or thematic funds, which are complex, is to just go and buy a diversified fund or a flexi cap fund. The latter can give you diversification across themes, sectors and also capitalizations.
Diversify is a trade-off so it will drag down your returns. Some return loss is inevitable in diversification but ensure that it does not put your goals in jeopardy just because they are diversifying.
Diversification must be within the contours of your long term financial plan and that must remain the guiding principle. Your asset mix must not go too far from the original mix as envisaged in your long term financial plan.
- Diversification is an ongoing process. You can also diversify in the best possible way by preferring index funds when the scope for alpha is limited. So, follow a dynamic diversification policy to ensure it is ongoing.
Be wary of international diversification. Many of them carry currency risk so you may end up being exposed to currency fluctuations. Ensure that the returns in such cases outweigh the costs.
