Why portfolio diversification helps

You may have a typical portfolio containing several stocks, bond funds and other assets because you believe that such diversified investments will not suffer large losses when the market crashes.

The 2008 sub-prime crisis, however, showed us that “diversified” investments cannot protect you during market crashes. So, why should you buy diverse assets? In this article, we show that the reason for buying diverse assets extends beyond simple diversification.

Return sources

That different assets decline by similar magnitude during market crashes means that your “diversified” portfolio is not always safe. But that should not deter you from buying different assets such as stocks and bonds! Buying diverse assets helps you in meeting different objectives, and, perhaps, also moderates your losses during market downturns.

Consider first the diversification objective. Your investment has two sources of returns — capital appreciation and income returns.

Capital appreciation is the return you get when you sell an asset at a price that is higher than the price at which you bought it. You are entirely dependent on the market to earn your returns from capital appreciation. Income returns, on the other hand, is what you get for holding the asset. This includes dividends from shares, interest income from bonds and rental income from real estate.

Your objective should be to create a portfolio that earns returns from both sources, not simply hold several “diversified” equity funds and bond funds hoping that they do not all fall in value when the market crashes! There is an advantage in diversifying your return sources. For one, when you combine assets that generate income returns with ones that generate capital appreciation, you are reducing your dependence on the market forces to earn returns.

For another, since income returns are more stable than returns from capital appreciation, the uncertainty of generating returns on your total investment reduces.

Purposeful investments

You should buy equity mutual funds to invest in capital-appreciating assets. For income-generating assets, your choice should be bank fixed deposits, direct investments in tax-free bonds and rental income from real estate investment, if possible.

You should consider gold investments not because gold “diversifies” risk associated with your equity investments. Rather, we are assuming that you, like most Indian households, would like to gift physical gold or ornaments to your son or daughter as part of your inter-generational wealth transfer. Instead of buying gold jewellery today, you can just as well invest in gold ETFs or e-gold and sell the investments at the prevailing market price when you actually want to buy gold.

What about other commodities? If you are comfortable with the derivatives market, you can invest in commodities that affect your lifestyle.

This is because inflation is a significant risk you face when you invest for the future. You should, hence, seek to invest in commodities that are the primary reason why prices go up in the first place! Buying crude futures, for instance.

Finally, you may want to explore what we call as the alpha source. Suffice it to mean that such investments will strive to generate returns even if the market declines! One such product is the arbitrage funds. This class of mutual funds attempts to generate returns by taking advantage of the difference between the spot market and the derivatives market.

Conclusion

Your portfolio may already contain all the investments that we discussed above. What we are asking you to do is to pre-define the reason for making such investments. You should invest in different assets not because an asset will always increase in value when another declines.

Rather, you should invest in diverse assets because they serve different purpose, as discussed above. Clearly defining the reason for buying each asset will moderate your suffering when all your investments decline during a market crash!

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at enhancek@gmail.com )

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