Diversification and how to take advantage of it

The old idiom, “don’t put all your eggs in one basket” is the essence of diversification. While most of us understand the wisdom of this idiom, many of us do not realize its importance in financial planning. Many of our readers know that diversification reduces risk, but letus try to get a sense, by how much is risk reduced through diversification. Let us assume that, you invest all your money in buying shares of a company. If the company makes a loss or goes bankrupt you may lose some or all your money. Now instead of investing in just one company, split your investment in two companies. The possibility of both the companies making losses is substantially lower than possibility of share price of any one company making a loss; the probability of share prices of both the companies making losses is 50% of the probability any one company making a loss. If you invest in three companies, the probability of all three companies making losses is just 25% of the probability of any one company making a loss; if you invest in four companies, the probability of all four companies making losses is only around 12% of probability of any one company making a loss. You can see that, the risk reduces exponentially as you add companies to your portfolio.

Risk Diversification in Stocks

Does this mean that if you add a large number of companies, say 50 companies, to your stock portfolio, your risk is virtually zero? The answer is no, because not all risks are diversifiable. There are two kinds of risk in equity investments, Unsystematic Risk and Systematic Risk. The risk of share price falling due to the company making a loss (like in the examples above) or any other unfavourable company specific event is known as unsystematic risks. Unsystematic risk is not just limited to company specific risks. For example, let us assume that, you invest in a bank stock. During the quarter, if the RBI hikes interest rates, the share price of most banks (including the one, you have invested in) are likely to go down. This is example of a sector specific risk.

Both company risk and sector risk are unsystematic risks. Unsystematic risk can be diversified by investing in a portfolio of companies. We saw in the previous paragraph, how adding companies to your portfolio reduced the company risk exponentially. Sector risk can be diversified by investing in companies across different sectors, so that, even if one sector is adversely impacted by some event, other sectors are not impacted and hence your risk is lower.

If the market falls due to global or local factors, then individual stocks are also likely to fall, even if there is no negative news pertaining to individual companies. The risk of share price falling due to the overall market movement is known as systematic risk or market risk. Market risk is caused by events which affect the whole economy of the country or even the world. Market risk cannot be diversified by adding more stocks to the portfolio, because all stocks are affected by market risk. However, some stocks are affected more by market risk and others are less affected. The stocks that are more affected by market movements are known as high beta stocks, while stocks that are less affected by market movements are known as low beta stocks.

So market risk is not diversifiable, unsystematic risk can be diversified to a large extent by investing in a sufficiently large number of stocks, both high beta and low beta, across different sectors and also different market capitalization segments. This is the principle on which diversified equity mutual funds work. We will discuss mutual funds in more details later in this post.

Diversification across different classes

Different asset classes, e.g. fixed income, equity, gold etc have different risk return characteristics. Investors should understand that, risk and return are directly related; higher the risk, higher the return and vice versa. Fixed income or debt has the lowest risk. Within fixed income, bank deposits and treasury (Government) securities are risk free securities. Gold is next risk grade; it has higher risk compared to fixed income, but lower risk compared to equity. Equity, generally, has the highest risk, but also gives the highest returns over sufficiently long investment tenure.

Different asset classes also outperform each other in different economic cycles. Fixed income outperforms equity in bear markets, while equity outperforms fixed income in bull markets. Similarly gold and equity cycles are different. For example, equity in India outperformed gold in the early 90s, but gold outperformed in the late 90s and early 2000s in the wake of the Asian currency crisis and the dotcom crash. Equity again outperformed gold from 2000 to 2008, but gold outperformed equity from 2008 to 2012. Equity is once again outperforming gold over the last 4 years or so.

No matter how much we dislike market cycles, they are inevitable and there will be times when some of your assets will perform disappointingly. By diversifying across different asset classes you can not only reduce the overall risk of your portfolio, but you also will be able to smoothen your portfolio volatility in different economic or market cycles. For example, if you diverse asset classes in your portfolio, in certain economic scenarios, when equity is underperforming, fixed income will give high yield and generate income from your portfolio. Similarly during recessions or severe bear markets, when equity falls 20% or even more, gold will appreciate in value.

Diversification enables better financial planning

We have different goals in life. Some goals are long term in nature, e.g. retirement planning for young investors, while others may be more medium term in nature, e.g. children’s education and also short term in nature, e.g. buying a house, vehicle etc. We have discussed a number of times in our post that, you should plan for individual goals.

Different asset types are suitable for different investment tenures and objectives. Equity and gold are suitable for long term goals. A mix of equity and fixed income may be suitable for medium term goals. For short term goals, you should invest only in fixed income. Similarly, if your investment goal is capital appreciation then equity and gold are the ideal investment options. If you have higher risk appetite and more aggressive goal, then equity is more suitable than gold. Within equity, you can invest in large cap stocks or midcap stocks depending on your risk appetite. If you need income from your investments, then debt is the suitable asset class.

A diversified mix of asset types can help you meet each of your financial planning goals without compromising the other. For example, you are saving for retirement and at the same time want to buy a house in 2 years time. If all your investment is in equity and the market crashes at the time you need to make the payment for the house, then you will have to sell a large number of shares (or units of equity mutual funds) to purchase the property. This will, in turn, compromise your retirement planning objective because when the equity market eventually recovers, you will have less capital. On the other hand, if you plan carefully and have investments in both equity and fixed income, you can purchase the property from your fixed income investment, without selling shares or equity mutual fund units. Diversification is an integral element of prudent financial planning.

Let us now discuss how you can take advantage of diversification.

Risk Diversification in Mutual Funds with lower capital outlay

To create a diversified portfolio, you need to invest in a sufficiently large number of stocks. Let us assume that, you need 50 stocks to create to an adequately diversified portfolio. The share prices of the 50 stocks may range from Rs 100 to Rs 5,000 per share. Remember, you cannot buy fractional shares through your stock broker. Even if you buy just 1 share each of the 50 companies, assuming the share prices of the 50 stocks are uniformly distributed in the Rs 50 to Rs 5,000 per share range, your minimum capital outlay can be more than Rs 125,000. To achieve adequate diversification through direct equity shares, you need a large capital investment.

Mutual funds, as discussed earlier, pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger than the investible capital of an average individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio. By investing, just Rs 5,000 in a diversified equity mutual fund, you can get diversification benefits that would have required a few lakhs, if you had invested directly in equity shares. You can also invest in mutual funds in even smaller amounts from your regular savings through Systematic Investment Plan or SIPs.

Diversification across Asset Classes

You can diversify across equity and fixed income, simply by investing in mutual fund hybrid schemes, variously known as balanced funds, equity savings funds, Monthly Income Plans etc. These funds invest in equity and fixed income in different proportions depending on their investment objectives. Equity oriented hybrid funds (also known as balanced funds) invest at least 65% of their assets in equities and the balance in fixed income and as such, are good investment options for moderately aggressive investors. These funds enjoy equity taxation.

Equity savings funds invest in equity, fixed income and equity derivatives. These funds usually have lower risks than balanced funds, because the derivatives portion of the portfolio is for arbitrage purposes (risk free). Moreover, these funds enjoy equity taxation. Equity savings funds are suitable for investors with a moderate risk profile, seeking both capital appreciation and income.

Monthly Income Plans invest most of their assets in fixed income securities. Their primary objective is to generate stable returns for investors. 20 – 25% of the assets of Monthly Income Plans (MIPs) can be invested in equities. Over a sufficiently long investment horizon, the equity portion of the portfolio gives a kicker to returns and can help these funds beat inflation in the long term.

Asset rebalancing with diversification

Diversification helps investors to rebalance their portfolio from time to time. Different asset types / classes grow in value at different rates during different economic cycles or market conditions. By rebalancing assets from time to time, investors can take advantage of price to value opportunities in different asset types. Financial analysis shows that, asset rebalancing can improve risk adjusted returns over a sufficiently long investment horizon (please read our post, Asset Rebalancing will reduce your portfolio risk and improve returns).

Mutual fund schemes with flexible mandates rebalance between different asset types depending on the relative valuations of the asset types. For example, flexicap equity funds adjust their market capitalization mix between large cap and mid / small cap depending upon the relative valuations and outlook of these market capitalization segments. Similarly, balanced funds rebalance their asset mix between fixed income and equity depending on the relative valuations of the two asset classes. Asset rebalancing limits losses in bear markets and, at the same time, ensures that the portfolio is well positioned to ride the next bull market.

Conclusion

In this blog post, we discussed how diversification is beneficial in terms of reducing risks, ensuring portfolio stability in different market cycles and in financial planning. We also discussed how mutual funds can be used to achieve multiple diversification objectives and benefits. Our opinion in Advisorkhoj is that, every investor should have a structured or at least semi structured financial plan to meet their different financial goals. Once investors define goals, they should determine their most optimal asset allocation and then work on building a diversified portfolio across different asset categories (e.g. mutual funds, ETFs, stocks, bonds and gold etc.) to help them meet their different financial goals.