Need
Portfolio Allocation is about getting the big decisions of Portfolio Equity (Inflation Protection) and debt (Capital Protection) balance right. Portfolio Allocation also allows us to choose the right level of volatility and growth combination that one needs for his financial goals and can comfortably work over a long period of time. Portfolio diversification is another dimension of Portfolio allocation. Diversification allows your returns to be protected from vagaries of individual companies, industries and economy. Diversification is one free lunch of investment available as diverse risky investments yield a less risky final portfolio. We will understand how.
Diversification
Diversification can be understood by understanding its opposite Concentration. Concentration is putting all eggs in one basket. A concentrated bet is putting your money on a narrow range of companies or industries as part of your portfolio to generate your investment returns. That is also a valid strategy if there is high level of familiarity and information that might also work for some investors. However, the risk in concentrated bets or putting eggs in one basket is that if that bet is wrong, if some information is not correct, if there is a flaw in analysis – your financial future is jeopardized. Therefore, it is advisable for common investors to use this as a strategy as they will usually lack all information and requisite analytical framework to analyze companies and industries. So, concentration is not recommended for critical financial goals or as a strategy for investment for most common investors.
Diversification on the other hand focuses on spreading the bet across all investment classes, industries, and geographies. That is Debt and Equity allocation covered in Portfolio allocation is first level diversified. In this we combine two very different investment class – a steady core debt portfolio which is an anchor with equity portfolio which is more volatile and has superior long-term returns. By combining this way, we get a combined portfolio which gets a better return with lower volatility.
Similarly, there are different levels of investments within debt and equity which have different characteristics that can be combined to produce less risk. The core idea here is portfolio is not concentrated so losses are limited, and the investment behavior of products are such that not all of them rise and fall at same time. This kind of diversification produces a less volatile and relatively stable portfolio which also helps investor to keep with the investment approach over time which in itself is a excellent positive outcome of diversification.
Equity Diversification
After a high-level diversification of Equity and debt we can further improve the portfolio by diversifying within equity and debt. Equity diversification primarily involves selecting stocks across industries like banking, IT, Energy, Automobile, FMCG etc. The approach allows one to capture all aspects of growth of all aspects of economy.
A second level of diversification is to allow for different sizes of companies. Based on market capitalization companies are classified as large, medium and small. Large companies provide lesser returns at a more stable and are less volatile. They represent established big size companies within the industry and are also a relatively safer investment within Equity. Smaller companies in medium and small are newer to the industry but are growing at a faster pace. So their returns are expected to be more but come with a greater risk and variability in performance. Just like combining equity with debt a combination of all industries and market caps within equity allows for a diversification within equities with appropriate balance on returns and risk as desired by investors.
Geographical Diversification
Another aspect of equity diversification is exposure to different geographies other than one’s own country. Geographical diversification can be understood by taking example of own employment.
Employment in a company ties future income streams to the company fortunes. And our own investment decisions should diversify away from that company. Why? In case of problems with the company then there is a problem of future income streams as well as additional investment risk in case our income and investment are not diversified.
Geographical diversification takes the diversification at a country level. One employment income, and most of assets like Real Estate, Debt investment and Equity investments are tied to a country. This investment approach is correct in so far as one’s investments need to perform in tune with that economy its inflation performance etc. For example living in India the investments in India will work in line with inflation so it is correct to have investments in India for residents. But there is also a need to diversify this exposure to some extent for some rare but potential risks that might happen. International equity exposure captures broader performance which is not correlated to own country. Moving away from home country bias in investments is another risk management strategy to protect against extreme events and helps to diversify equity.
Debt Diversification
There is diverse set of instruments available in debt as well. There are sovereign backed guaranteed debt like bank deposits, PPF, PF investments. There are other debt instruments like corporate FD, Gilt deposits, State Loans, PSU bonds. A lot of these also have varying tenures of maturity. This is handy to match ones need and timelines to debt maturing at different times. Debt investments also have diversity in terms of credit risk as provided by underlying investments like AAA, AA with varying return and risk characteristics.
All of these happens within a macro economic environment of interest rate changes based on economic cycle. So there is option to diversify debt across instruments and across maturity and credit ratings to completely capture all aspects of debt market performance.
Setting and Maintaining Diversification
Portfolio allocation and diversification within major components of portfolio is a decision which reflects the risk or variance the investor is willing to take on a long-term basis to achieve a certain return. The diversification set up provides the risk management and return characteristics. By setting and maintaining the diversification over long term the investor will get the returns in tune with long term performance. So an important part of the Portfolio allocation and diversification is to review and revert to the original component weights of all sub parts of portfolio. This is the process of rebalancing to original weights that need to be done periodically like annual or quarterly or based on movement of the underlying. A topic for discussion later.
Summary
- Portfolio diversification is a free lunch by which diverse investments balance risks and returns and provide a better risk adjusted performance then concentrated portfolio
- Deciding on long term risk orientation and setting a portfolio diversified to that risk level is a primary decision to be taken early in investment
- Setting and maintaining the portfolio to allocated levels of diversified equity and debt over the investment duration is another key component of investment.
