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Portfolio diversification: A correct asset allocation in diverse asset classes helps to reduce concentration risk and provide consistent risk adjusted returns.
They say “Don’t keep all your eggs in one basket”; which means that if due to an accident, two of you baskets break, you will still have a few eggs held safely in your 3rd and 4th baskets, helping you make your omelette and not sleep hungry.
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The same is true about investments. If we invest all our money in equity mutual funds and a few mid cap shares and the broad stock markets crash, we lose our long-term savings. On the other hand, if we have some money kept in separately on bank fixed deposits, RBI bonds and gold, we would still be safe than sorry.
The basic allocation of our wealth happens between physical assets (e.g. real estate and gold) and financial assets. The allocation across financial products happens in asset classes like equity and debt while some money can remain in cash. In addition to this some investments can be made in a hybrid mode in a combination of debt and equity e.g. a balanced mutual fund.
Too much time and attention is spent on questions like “Is this the right time to invest?” and “Is this the right investment product for me?” The more important questions are “What is the right asset allocation for me as per my risk profile?” and “What is the ideal diversification formula for me?”
A correct asset allocation in diverse asset classes helps to reduce concentration risk and provide consistent risk adjusted returns.
We can diversify our portfolio by investing in asset classes such as stocks, bonds, real estate, gold, and private equity, which can be further subdivided by diversifying within each asset category. To reduce risk, if we invest 50 percent of our money in equities, we can diversify it among several sectors such as banking and financial services, metals, healthcare, Information Technology and more.
Diversification across a variety of asset classes with minimal correlation between them reduces portfolio risk by allowing different asset classes to perform well at different points of time, during different economic cycles and also during unfortunate global events like Covid-19 and the earlier global financial crisis during 2008.
In addition to risk mitigation, it is also important to add the time dimension to portfolio diversification. Our individual investment goals can be divided into three time periods - long term, medium term, and short term and the portfolio construction should match these time frames. In general, equities can be a part of a core portfolio for long-term goals, while fixed-income investments are recommended for short-term goals, and a mix of equity, debt, and gold for medium-term goals.
Depending on the investor’s age, risk-taking ability and return expectations, an appropriate portfolio construct may differ from investor to investor. The first step in building a portfolio is to put money in a safe fixed income product that can last up to six months in case of an emergency.
Once the emergency funds are in place, the investor can begin constructing a portfolio to meet his / her financial objectives. Identifying financial goals and risk-taking abilities based on the income profile combined with the appropriate asset allocation is the most important element in portfolio construction.
A brand-new investor should start with mutual funds, and multi-asset funds serve as a solution for investors by taking care of asset allocation decisions. Because most multi-asset funds invest broadly across three asset classes, such as stock, debt, and gold, using proprietary models that reduce personal biases in asset allocation, they should make up at least half of the portfolio with the rest diversified among equity schemes, balanced advantage funds, debt funds and Gold ETFs.
As an investor's investing journey proceeds, his/her portfolio may become overly diversified, with little or no benefit on risk reduction. All investors, whether experienced or inexperienced, should review their investment portfolios at least on an annual basis, to verify that they continue to remain appropriate for their risk profiles, and seek help from an expert advisor if necessary. As an investor's portfolio expands & experience increases, he/she can progress from mutual funds and ETFs to more sophisticated investing channels such as small case investing, portfolio management (PMS), private equity, and alternative investments.
The most important things to remember when putting together a portfolio are to have an investment goal and an asset allocation plan that is optimised for your risk profile. Low correlation between asset classes in well-diversified portfolio coupled with low overlaps of investment instruments in a tax-efficient manner, as well as regular monitoring, should serve as the foundation for any strong portfolio.
The author, Abhijit Bhave, is CEO at Fisdom Private Wealth. The views expressed are personal
(Edited by : Anshul)
First Published: Dec 10, 2021 6:28 PM IST