Balance out your investments
We tell you why you should not buy equities alone and help you strike the middle path between risk and return. Lisa Pallavi Barbora writes. Why diversification worksbusiness Updated: Mar 01, 2013 22:12 IST
While committed equity investors would swear that in the long term this is the only asset class worth investing, conservative investors would stick to their fixed income or debt instruments come what may. Both would have their own set of arguments: equity investors would swear by liquidity and the fact that it delivers above inflation returns; conservative investors would cite safety of capital and risks of market volatility.
Unfortunately, either of the decisions is not the one to stick to for either set of investors in the long term. For a long-term portfolio, equity is a must, but a balance between equities and debt is strongly advised. No asset class, including equities, consistently delivers high positive returns all the time.
To come around the problem, you would need to diversify with the objective of minimising risks for a particular return. Risk here essentially refers to the chance of making negative returns. We took 30-year data for equity (Sensex), gold and fixed deposits and compared returns across periods for diversified portfolios. Analysis shows that diversification helps.
It's true that in the last 10 and 20 years, the Sensex's compounded annual growth rate (CAGR) was 19% and 11%, respectively. It is also true that in the last five years, the Sensex's CAGR has been -0.86%. But this is not the only 5-year period when equity didn't perform: between 1998 and 2002, the Sensex delivered a CAGR of -1.6%. What this means is that there are periods when even long-term assets like equity can give negative return.
If your portfolio only had equity in these periods, you would be sitting on a capital loss. But had you included other assets such as gold and fixed deposits to compliment your equity exposure, the overall portfolio losses would be negligible and you would have minimised the downside. Says Raghvendra Nath, managing director, Ladderup Wealth Management Pvt. Ltd, "The primary objective of diversification is to reduce risk as a suitably diversified portfolio is likely to have less volatile returns. Also, diversification helps in hedging, when it comes to assets like equity some amount of hedge can be created by diversifying into other assets."
Regardless of how much equity exposure you have, diversification helps. Take a portfolio with 80% exposure to equity, in the two negative return periods you will see that the returns were better than if it had 100% equity exposure(see graph). You can argue that a portfolio invested only in equity would have delivered better average return of 17.3% (average of the five-year period returns) as compared with the portfolio with 80% equity which delivered average return of 15.1%. What happens if you get caught in the wrong five-year period or the wrong decade? Says Sumeet Vaid, founder and chief executive officer, Ffreedom Financial Planners, "Investment return is separate from investor return. For example, HDFC Top 200 has given around 22-23% CAGR in the last 15 year, but individual returns will differ." Your own returns will depend on the period when you were invested.
On the flipside, if you are a very conservative investor, then diversifying into equity helps enhance your overall returns. For example, in the conservative portfolio in the graph, the average return is 9.2%. Compare this with an average return of 7.9% for a pure fixed deposit portfolio and 4.8% only for a portfolio invested only in gold.
Which assets to choose?
The asset classes and the proportion you choose really depends on your long-term goals and your comfort with risk. For the purpose of this story, because of data constraints, we have considered gold and fixed deposits along with equity. However, you may also choose to diversify into any asset, including real estate or fixed income mutual funds.
How much equity you choose to keep as a proportion of your overall portfolio would also depend on your financial objectives.
Vaid says, "We start with a financial plan and all transactions are subject to that. Asset choice is based on the goals. For example, for a long-term high priority goal will have a 70% allocation to equity."
Vaid goes on to talk about further diversification where the equity allocation is diversified on the basis of market capitalisation and fund manager profile. Fixed income allocation may be diversified on the basis of maturity periods.
What should you do?
Chasing asset returns may get you superior earnings at times; at others, it may eat into your capital. In case of equity, there is no way of knowing the time period for negative returns in advance, so a wiser approach is to diversify your portfolio into other asset classes. Use your financial objectives as checkpoints to decide your allocation across assets.
If you are already taking the help of a financial adviser, then you have an organised approach to investing through a financial plan which inherently embraces diversification into asset classes based on the objectives and investment time horizon. Nath says, over and above this, there is also a conscious attempt at diversification to reduce risk. According to Vaid, rebalancing of asset allocation at a suitable frequency is the key to effective diversification.
On the other hand, if you have just embarked on the path of wealth creation and don't want to deal with the problem of tracking different assets, there are always readymade products available such as hybrid mutual funds that invest across a combination of equity, fixed income and gold.