Diversification will lower investment returns!

It is important to diversify a portfolio, but it is even more important to understand that diversification will typically lower portfolio return and not enhance it!

Technically, diversification is for risk reduction,or to be precise  - reduce the daily ups and downs in the portfolio value (aka volatility). However, volatility reduction almost always results in return reduction, unless there is some kind of tactical allocation to assets.

Diversification is necessary, but too much of it can hurt. Consider the standard analogy used: do not put all your eggs in one basket.

Yes, that make immediate sense. However, how many baskets should I use? Two or Twenty?

While a single basket is risky, the risk returns if I have twenty baskets. I might actually end up losing efficiently or some baskets.

Something similar happens with investing too. A portfolio with 100% equity can either produce a real return (higher than practical inflation rates) or fail to beat a fixed deposit or even result in loss of capital.

Now, this is a chance reasonable people will not take. So they spread the risk by adding one more asset class. Typically - fixed income. For the simple reason that it is not volatile.

Take the case of equity-oriented balanced funds. Just by adding 25-20% of bonds, the long-term risk decreases by 5-10% without significantly affecting the returns: Balanced Equity Funds: the low risk, high reward option.

It is important to recognise the role of rebalancing here.

Rebalancing refers to a asset allocation reset. If we start with 40% fixed income and 60% equity and after a year so, notice that the equity has become 80%, the risk increases. The portfolio is rebalanced if the asset allocation is reset by shifting 20% from equity to fixed income to maintain the 60:40 proportion.

Balanced funds have some strategy to book profit in one asset class and shift to another periodically. This could be once a month, once the asset allocation deviates the investment mandate or tactically.

Whatever the method adopted, rebalancing is essential to reduce risk and possibly enhance  or diminish returns!

Now, it is easy to imagine the impact of increasing exposure to bonds (ignoring taxation for now).

diversification

The NAV movement of HDFC Balanced (equity oriented) vs DSP BR Monthly income plan (debt oriented fund) is shown above.

During a sideways market (2 years), the debt-oriented fund looks great. However, if the upward movement of the equity market is considered over 8 years, the HDFC Balanced fund, despite its higher volatility wins hands down.

There are many important learnings here:

  1. Volatility is not an enemy. It is essential to get real returns. However, too much of it can be harmful during times when the market is not moving up.
  2. Diversification is a double-edged sword. If we aim to reduce day to day portfolio volatility, returns will reduce.
  3. Rebalancing is also a double-edged sword. The MIP fund must have started out with 15-30% equity. Had that grown untouched, the difference between the two funds would be lower, at the cost of higher MIP fund volatility.  Rebalancing lowered volatility , but also reduced returns of the MIP fund.
  4. Knowing how much to diversify is hard (there are algorithms to do this, but let us not get into that now.  They have their own limitations). Some amount of fixed income reduces risk without impacting returns adversely. Increase the exposure and the purpose of investing in equity could well be lost.
  5. Knowing when to rebalance is also a problem. Sometimes rebalancing increases reward by lowering risk and sometimes lowers both risk and reward.

So what should be done?

There is no optimum or best method to optimise risk and reward. If this is important to you, there are some basic actions necessary:

  1. Track the net return of your portfolio. That is the XIRR of all equity, fixed income, gold and other transactions. Trackers like Mprofit, Perfios, Value Research do this easily.
  2. Track this XIRR periodically. Maintain a spreadsheet for this.
  3. Avoid instruments which have lock-ins - FMPs, bonds etc. We should be able to buy and sell freely from instruments. Mutual funds and stocks are great in this regard.
    • In other words, avoid random lump sum purchases, just because it is easy to!
  4. Systematic investing helps a lot. Even those who wish to time the market should systematically feed the liquid fund.
  5. Think twice before adding new asset classes like real estate or gold. Real estate cannot be used for rebalancing! Gold can be transacted freely if purchased in ETF or gold fund form.
    • There are many mutual funds which invest in equity, bonds and gold at all times. To see what I mean, have a look at the returns since inception and NAV movement of funds like
      • Axis Triple Advantage Fund
      • Canara Robeco Indigo
      • Kotak Multi-asset
      • Quantum Multi-asset
      • Peerless 3-in-1

In order to make investment decisions, we should be able to visualise the growth of our portfolios. Subra often says, "the asset allocation that lets you sleep in peace, is the right allocation for you".

I agree with this. However, it is important to recognise that deciding such an asset allocation will require time, experience, conviction and a strong filter to ignore random opinions floating around at Asan Ideas for Wealth.

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