Sometimes, an idea, phrase, or action becomes so commonly used that we take them for granted and don’t stop to think about why they are used. So, can we pause momentarily and ask, “Why should I diversify my investment portfolio?”
When we push ourselves into a corner and force ourselves to answer, we will probably be reminded of the quote, don’t put all your eggs in the same basket. Then, the obvious inference is that we diversify to reduce portfolio risk.
But is that what we do in practice? I think a different perspective is necessary to prevent di-worsification. Let us ask ourselves how we try to “diversify” in real life.
- We see international stocks doing well. So we want some of that.
- We see gold doing well. So we want some of that.
- We see midcaps or small caps outperforming. So we want some/more of that.
- If we see someone make a big gain with cryto, yes, that is “needed” for diversification.
- REITs, Gilts, and anything shiny need to find a place in our portfolios.
We want so many “10-15%” exposures that we want the definition of 100% change to 300%.
If all the members of my portfolio are shiny simultaneously, then I am guaranteed two things. (1) I am happy now, and (2) they will simultaneously tank sometime soon. This is not how diversification works.
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By chasing after shiny objects but looking at their recent returns, we have suckered ourselves into buying current winners. That sounds great, but the problem is, if our portfolio only has winners today, then our portfolio will have only losers soon. That is the opposite of diversification.
Ideally, at any given time, a portfolio should have some asset classes or types that do well and some that don’t. This sounds counterintuitive, but it is highly beneficial if we stop looking at individual asset, fund or stock returns and look at the portfolio returns.
When the portfolio has only winners who turn into losers or vice versa, the portfolio return will swing wildly from extraordinary to devastating. Surely we don’t want that. We want our portfolio returns to fluctuate less, and that can happen only if it has some winners and some losers at all times.
A simple mix of equity and fixed income can achieve this. However, there is one more requirement. It is not enough if the portfolio returns fluctuate less. They must fluctuate less about our expected return (after tax). This is achieved using the right asset allocation (how much equity and how much of fixed income).
Next comes the maintenance. These asset classes will not remain at the same levels. Most people let them grow unmanaged like a wild garden because they are worried about taxes. They incorrectly believe they can “adjust” the asset allocation by adjusting the monthly investment – this will take longer and longer and soon defeat the purpose of diversification and asset allocation as the portfolio return will fluctuate more and about any arbitrary level (not your expected return). See: Can I rebalance my portfolio by adjusting my SIP amounts?
Please rebalance the portfolio or, in other words, reset the asset allocation when each asset class deviates by at least 5%. See: When should I rebalance my portfolio?
Finally, remember, most people cannot determine the impact of adding a little good, crypto, international equity, etc. So, it is best to keep things simple. Equity and fixed income alone will do.
Once you decide on the right asset allocation, decide on the de-risking plan – how equity should be reduced and compute the investment required to achieve your target corpus. The freefincal robo advisor tool automates this process for you.
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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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