The Benefits of Diversification

The Benefits of Diversification

Think of the old proverb; “Don’t put all your eggs in one basket.” 

In other words, don’t put your hopes, dreams and future (or money) all in one place, because if that resource fails, you’ll lose everything. 

So, in this situation, the eggs represent your money and the basket represents one type of investment (mutual fund, stocks, real estate, bonds, etc.). 

 Virtually every financial advisor will encourage you to spread your money across different types of investments called asset classes.

 A client once said to me, “Why don’t we put all of our money into the five big banks and be done with it?”

 In his mind they were five big “blue chip” companies that at the time had done very well and were not only the envy of most banks around the world, but most companies, too. Although he was right that they were well-run companies and had been great investments to date, he missed a very important point; Diversification isn’t just about the number of securities you own; it’s about protecting against unknown outcomes that can derail your net worth.

 Although the five big banks are separate companies, they are influenced by similar factors and react similarly in different environments. If something unexpected happens, they’re likely to be affected in the same manner. This could work out for the best, but it could also affect the other way.

 If you were a cricket coach and had to pick the best players; would you pick all opening batsmen or would you pick only Fast Bowlers? 

Ideally you would pick players for each position, even if they were not as good as the opening batsmen or fast bowlers. 

Virat Kohli, MS Dhoni, M Shami and R Ashwin, all have a role to play in the success of the Indian cricket team and the role each of them plays is totally different from the other. 

They are all required and they all complement and not supplement each other in the team to produce the best result.

 Similarly while deciding on the portfolio mix, you must keep in mind that there are many financial environments, or different business cycles, on the horizon. By restricting your investments to securities that are thriving in a current financial summer so to speak, you leave yourself terribly exposed to a potential financial winter.

 When building your portfolio, don’t pick individual companies or securities just because they are in favour or highly rated. Look for investments in various asset classes that complement each other and aren’t influenced by the similar factors.

 Diversification is a method of portfolio management whereby an investor reduces the volatility (and thus risk) of his or her portfolio by holding a variety of different investments that have low correlations with each other.

The basic idea behind diversification is that the good performance of some investments balances or outweighs the negative performance of other investments. 

 It is best to diversify across different asset classes. Stocks, bonds, FDs, PPF, Gold and real estate are common asset classes. One common move is to invest in both stocks and bonds, because the stock and bond markets are historically negatively correlated, meaning that when the stock market is up, the bond market is usually down and vice versa. Real estate and foreign stocks are other asset classes that are also used to diversify portfolios.

Diversification does not guarantee millions in riches, but it does reduce risk. It’s one of the most fundamental, important investment concepts; one of the first pieces of investment advice most people get.

 Keep in mind that diversifying your investment portfolio is not a get-rich-quick approach for building wealth. Its goal is to soften the blow when the market drops. 

 However, risk can never be eliminated completely. 

 Diversification is one of the hallmarks of the “Modern Portfolio Theory” and is one of the relatively few concepts most investors seem to inherently understand. 

 What are some of the benefits of diversification?

Diversification offers a host of potential benefits, such as lowering portfolio volatility, increasing risk-adjusted returns, and reducing reliance on any one company, sector, country, etc. 

 Three key advantages of diversification include:

  1. Minimising risk of loss – if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment.
  2. Preserving capital – not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.
  3. Generating returns – sometimes investments don’t always perform as expected, by diversifying you’re not merely relying upon one source for income.

What makes a diversified portfolio?

To diversify your portfolio, you need to spread your capital across different asset classes to reduce your overall investment risk. These should include a mix of growth and defensive assets:

  • Growth assets include investments such as shares or property and generally provide longer-term capital gains, but typically have a higher level of risk than defensive assets.
  • Defensive assets include investments such as cash or fixed interest and generally provide a lower return over the long term, but also generally a lower level of volatility and risk than growth assets.

A diversified portfolio means spreading risk by investing:

  • Across different asset classes such as cash, fixed interest, property, Indian and international shares
  • Within asset classes such as purchasing shares across different industry sectors
  • Across different types of funds and different fund managers if investing in mutual funds.

No particular investment consistently outperforms other investments.

For example, during periods of increased share market volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property, that may perform better over the same period, the returns from these investments can help smooth the returns of your overall investment portfolio.

So, by diversifying your investments, you can achieve smoother, more consistent investment returns over the medium to longer term.

But there’s an additional benefit of diversification, one that is rarely discussed; something called a “Diversification Premium.” 

This mysterious sounding potential benefit is best explained by analyzing a question I’ve heard repeatedly in our meetings with investors, in one variation or another. 

 It goes something like this, “I’m fairly confident that I can earn an assured 6% return over the next 25 years using ‘safe’ investments. I’m not so sure that the stock market is going to be all that strong over that time, though. I’m not convinced that I could do much better than 6% on average, if I invested in a bunch of different stocks. So why take all that added risk just to end up in the same place?”

 It’s not a terrible question, but there’s actually a surprisingly simple, and rather convincing reason to do it and that is simple maths. It is maths that so-often produces the diversification premiums noted above.

 We could spend forever creating different “what ifs”, but for the sake of clearly illustrating the concept of the “diversification premium”, let’s take a look at two different hypothetical portfolio constructions.

 Portfolio (A)

For our first portfolio, let’s imagine that you find a hypothetical investment that will earn you 6.5 % annually over a 25-year period. As the chart below illustrates, by the end of the 25-year period, your Rs 10.0 lacs portfolio will have grown to Rs 48.28 lacs.

 This portfolio assumes Rs 10.0 lacs is invested in a single investment, which earns 6.5% annually. It is not meant to represent any specific investment, nor meant to infer any guarantee of success, nor does it take any tax implication into account.

 What if, however, instead of putting Rs 10.0 lacs into a single investment that returned 6.5% annually, you split the portfolio into separate investments that, together, averaged the same initial6.5% per year? 

 How would that impact the cumulative balance of your retirement portfolio?

The precise answer, of course, depends on your exact returns – and to an extent, even the sequence of those returns (the order in which your returns occur). 

 Nevertheless, it’s entirely possible that through diversification, you could end up with a portfolio that earns the same initial average return of 6.5% as our first hypothetical portfolio, but which, as a result of a “diversification premium,” leaves you with a substantially higher balance in your retirement portfolio after the 25 years.

 Portfolio (B)

Let’s say that we construct a new portfolio, using the same Rs 10.0 lacs we started with above. 

Now, however, suppose that the Rs 10.0 lac is evenly split evenly among five investments. 

Let’s say you decide to keep Rs 2.0 lacs as cash in hand at home, which earns zero interest, 

You put Rs 2.0 lacs in a savings account, which gives you an interest return of 3.0%, 

You invest Rs 2.0 lacs in a FDR, which gives you a 6.0% return. 

You buy Bonds or Corporate Deposits scheme, NCDs or Hybrid Debt Funds worth Rs 2.0 lacs, which give you a return of 10%, and finally,

You invest Rs 2.0 lacs in an Equity mutual fund, which gives you a return of 13.5%.

Together, these five investments produce an initial average annual return of 6.5%, the same as our first hypothetical portfolio.

Calculation of Year 1 Average Return for Portfolio (B)

It would be easy – perhaps even logical – to assume that since our two hypothetical portfolios initially have the same average annual return as one another, that they would produce identical total portfolio returns over the 25-year timeframe. When you do the math and play the scenario out, however, the results are anything but identical. In fact, as illustrated in the chart below, over the course of the 25-year period, our second hypothetical portfolio would grow to over Rs 83.86 lacs. That’s almost double the total for our first hypothetical portfolio!

Isn’t Maths funny sometimes? 

In our example above, since there are no sequence of returns variables to contend with; the difference between the two portfolios is attributable entirely to the “diversification premium.”

Why is this happening though? How can two portfolios that begin with identical returns produce such dramatically different results over the long run? 

 For the math nerds (like me), let me explain it like this; although initial portfolio returns are identical; both of our hypothetical portfolios would grow by 

Rs 65000 after the first year, the compound growth of the higher-returning investments in the second portfolio, over time, more than make up for the lower-returning investments. This results in a progressively higher average weighted return for the second portfolio, culminating with roughly an 8.88% CAGR return by year 25.

 While most investments tend to rise over time, especially over long periods of time (i.e. 25 years), there are no guarantees, and even the best of investors pick the occasional long-term loser. 

Nevertheless, for many savvy investors, there’s a real, quantifiable, and often sizeable “diversification premium” that can be achieved through proper portfolio construction. 

 So the next time someone tells you that they’ll make a 6.5% return, just remember that all 6.5% returns are not created equal.

 Your diversification strategy will also be based on and influenced by your risk profile, age, regularity of income, financial goals, time horizon, years to goal, current market situation and other such factors, which your financial advisor can help you evaluate.

Diversifying your portfolio is important, but you don’t have to figure it out yourself. Talk with your financial advisor about your options and devise a suitable strategy.

 Happy Investing!

Stay Blessed Forever!

Sandeep Sahni

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Note: All information provided in this blog is for educational purposes only. They don’t constitute any professional advise or service. Readers are requested to consult a financial advisor before investing as investments are subject to Market Risks.

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