Investors often add 10% of this and 10% of that and claim they do it for “portfolio diversification”. This and that refer to asset classes or products that have recently done well. My favourite response is, now that you have added this/that, how do you know if your portfolio is diversified? What is the impact of the addition? Has it made a difference?
Most people who claim they do this for “diversification” have no clue about the impact of their actions, primarily because they don’t care. They see something shiny with great returns in the recent past, add it and assume the diversification is taken care of. Unfortunately, most such actions could only mean clutter with no meaningful impact.
Let us discuss how to quantify portfolio diversification. Let us start with a 100% equity portfolio. So, the diversification is essentially zero. What happens when you replace 40% of equity fixed income?
If the portfolio return swung from -40% to + 125% earlier, it could swing from -10% to 70%. That is the primary benefit of diversification. It reduces portfolio volatility. See the charts here: Why is diversification the only free-lunch in investing?
At 30%/40%/50%, the benefit of adding another asset class (especially when its risk-reward profile is distinctly different) is fairly intuitive, and quantification is not necessary to justify the inclusion.
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But what if you want to add 10% or 15% of international stocks, gold or silver, etc? There are two issues here. One, the new “asset class” is just as risky as equity (or, in some cases, fixed income) and two, the exposure is small.
In such a case, it is better to justify the inclusion with numbers before inclusion, and it must be monitored after inclusion to see if the decision makes sense. How many people do this? Practically no one. Everyone “assumes” a little bit of this, and a little bit of that offers “diversification benefits”.
Can we do better? Can we be more responsible for our own money? We have already published the math and the charts one should look at before investing (with gold as an example). For example, Can I add 10-20% gold to my 15-year investment portfolio? The upshot is there is no tangible benefit in such small gold exposure.
Inspite of this, if you still like the “small gold exposure”, we recommend the following (fully aware most investors will not care much for it).
- After the gold purchase (for example), note the total portfolio value (equity + fixed income + gold) once a month.
- Compute the monthly change in the portfolio value, aka the monthly return.
- After at least one year, determine the standard deviation of these returns. All spreadsheets have a simple command for this.
- Find out the standard deviation if you had not invested in gold and only invested in equity and fixed income. Is there any noticeable difference? The more data you have, the more reliable the result.
- Similarly, find out the maximum drawdown (fall from an all-time high) and the difference in returns (with and without gold).
Yeah, unless you are a total numbers nerd, this is too much work. Easier to assume without evidence that what we did is right. But this is the way to go if you prefer evidence to prove or disprove your actions!
Then, there is the question of asset rebalancing. That small exposure will change over time. Most assume they will “adjust” future investments and reset the asset allocation instead of rebalancing and paying taxes. Sadly, this essentially defeats the purpose of diversification (unless we are lucky)
Easier to buy only equity and fixed income and keep it simple. The justification is then intuitive. There is less hassle and less clutter, and you can sleep better. But what about FOMO? How to address the FOMO about FOMO?!
If your priorities are returns, then portfolio clutter is inevitable. Shift it to goal-based investing and accumulating a target corpus. That would reasonably keep FOMO in check – at least for some! See: How I manage my goal-based investments in auto-pilot. A useful tool: Review your goal-based investment portfolio with this auditing tool.
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Dr M. Pattabiraman (PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over 14 years of experience publishing news analysis, research and financial product development.
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