Don’t diversify mindlessly

You are unlikely to significantly reduce downside risk by applying naïve diversification principles

Diversification, one of the most used words in personal finance, is, perhaps, also one of the least understood. In this article, we discuss some issues associated with diversification. We also suggest a method to create an emotionally satisfying diversified portfolio.

‘Shield against ignorance’

Warren Buffett famously said that “diversification is protection against ignorance.” The Sage of Omaha can manage a concentrated portfolio and absorb consequent loss, if any. Can you?

You diversify because it gives you emotional satisfaction. Suppose, you want to invest in an active equity fund.

What if the fund underperforms its benchmark index? You may regret your investment decision. If you instead invest in three active funds and two outperform, you are happy.

But what if two of the funds underperform? You may comfort yourself with the fact that you diversified and yet failed. From a behavioural perspective, you diversified and failed (error of commission), which is better than failing without diversifying (error of omission). This is one reason why many individuals diversify. The second reason is that the future is uncertain. Diversification is a way to moderate our fear of uncertainty.

The problem arises when you have to create a diversified portfolio. You should aim to select assets or products that are weakly correlated with each other when the markets decline and strongly correlated when markets move up. That way, your portfolio will carry lower losses when markets decline and generate higher returns when markets move up.

Creating such a portfolio using a technique called full-scale optimisation is easier said than done. So while you want a diversified portfolio, you do not actually choose your investments accordingly. The typical process is to buy one investment product at a time, regardless of the correlation the product has with existing investments in your portfolio.

And yet you hope that your ‘diversified’ portfolio will protect you during market declines. In fact, your portfolio may well have assets that are weakly correlated when the markets move up and strongly correlated when markets decline. So, what should you do?

Mindfulness

You should first become aware that you are unlikely to significantly reduce downside risk by applying naïve diversification principles. Remember, you need stable cash flows and upside returns for your goal-based portfolios. The stable cash flows provide certainty to achieving the goal while the upside returns help you align your required returns with expected returns.

You should invest in bank deposits to earn stable cash flows. If you have lump-sum money, invest in cumulative fixed deposits with the maturity matching the time horizon for your life goal.

For instance, if you want to buy a house in seven years, invest in a seven-year fixed deposit. You should also create recurring deposits using your monthly income. Both cumulative and recurring deposits provide maturity value of your investment. That way, you know today how much you will receive when the deposit matures.

Your equity investments should preferably be in large-cap index funds through a systematic investment plan. The index is constructed with rules that ensure that important sectors contributing to the Indian economy are well-represented.

You, therefore, have a ‘sector-diversified’ portfolio. Note that index funds will hold cash and charge fees, which will drag its performance against the index. Finally, bear in mind that even a well-diversified equity portfolio will be exposed to market risk.

The upshot? Unless you apply sophisticated models, do not invest in several asset classes or investment products hoping to reduce risk.

Rather, aim to match the investment cash flows with your goals. You would have then invariably diversified using bonds (bank deposits) and equity (index funds).

The author is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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