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Diversification involves investing in more than one asset class to reduce your potential risk. If you put all the eggs in one basket, you ought to suffer in case an asset class fails to perform well. Since, the main purpose of diversification is to reduce risk, one might argue that investing in government securities is also considered safe. However, being an investor, you might not be able to earn adequate returns which might defeat your objectives of financial planning and investing.
Secondly, why not invest 100% in debt, being less riskier than equity. This might not fulfill your future needs as Interest on debt is taxable and after tax returns for debt may seem too low for an investor like you who wants to earn a good return on your investment. Investors should have some growth oriented funds such as equity to be coupled with debt for generating better returns.
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Investing in individual asset classes might be risky due to excessive volatility as observed during the past few financial years. We hope that this helped you to realize why diversification is the key. However, not always diversification leads to better returns. In case, an asset class is performing really well but on the other hand, other stocks in your portfolio have declining returns, you fail to earn a better return.
Lets understand this with an example, after the crash of equity in 2008 crisis, it reversed and gained 94% with other asset classes providing negative returns reducing the portfolio return to less than 30%. Hence, Diversification helps to reduce risk but might not always end up providing better returns. Don’t over diversify as it can only reduce risk up-to a certain limit.
As an investor, you all might know that both risk and returns should be managed to attain the financial individual objectives. But the question arises, how should a retail investor allocate funds through assets in order to earn a decent return with low risk?
Your portfolio should be allocated and reallocated based on your individual needs. You should take following thumb rules into consideration:
1. Assess your current asset allocation:
If you are a first time investor as well as a risk taker, you can start with investing a smaller amount in volatile equity in order to understand the risk element involved while investing. But, you need to be especially careful while doing so. Investing in hybrid funds is also considered good if you have entered into investing for the very first time.
Hybrid Funds: Hybrid funds are also known as asset allocation funds is a classification of mutual funds or ETFs and involve two or more asset classes with a mix of stocks and bonds.
And if you are already investing with a specified portfolio and asset class, it is important for you to assess your current position and ensure that the portfolio coordinates with your financial goals depending on their specific and overall risk and returns.
Diversifying into gold or other alternative investment can reduce the risk status from aggressive to moderate.
2. Investing into debt products:
Investing completely into equity or debt can be risky and might even offer low returns when considered individually. As an investor, your goal should be to create a liquid corpus in order to take care of expenses and emergency and debt funds can fulfill the purpose when combined with other asset classes.
3. Consider your risk appetite:
On the other hand, equity investment can be allocated in your portfolio based on a thumb rule of 100 minus your current age, as younger investors invest less amount and can bear the loss burden easily as well as have a longer investing horizon. However, old investors invest huge amounts altogether and the loss might seem painful. Also, while investing in equity, risk appetite being the risk an investor is willing to take should also be considered.
The entire allocation should not be to equities. The investment portfolio, regardless of the time frame, should be balanced. Never put the entire money into equity just because all the goals are far off. You can also consider investing in index funds or fixed income funds as they further help you hedge against market uncertainty and volatility. Keep a watchful eye on commission and fees, try to compare it with the return you are getting.
4. Consider dynamic market conditions:
The asset allocation should not ignore the market conditions, it is important to adjust your securities, risk and return to deal with the current situation. An asset class trading at elevated valuations will have higher risk compared to an asset class trading low.
5. Don’t ignore other asset classes:
Apart from investing into debt and equity, you should not ignore other asset classes and alternative investments, derivatives, real estate, ETFs, REITs and gold. Real estate is highly illiquid whereas gold can act as a hedge against rupee depreciation. However, as an investor, around 20% should be invested into international equity as it is considered a better alternative to gold.
Mutual Funds as discussed in our previous articles already provide a diversified portfolio and hence fulfill the ultimate purpose of optimum return and low risk. However, you should consider hidden cost before investing in ETFs and mutual funds. Get out earlier if the markets are overvalued, and wait a little longer if they are down. A fixed formula can be risky. To achieve a diversified portfolio, look for asset classes that have low or negative correlations so that if one moves down the other tends to counteract it. Create your own virtual mutual fund portfolio.
Investing can and should be fun!
Till then, keep reading and investing!