For investors, profile-based risk diversification ideal one

The role of diversification in investing has been discussed in many instances by the experts and it’s proven that it helps in not only reducing the risks, but also generate better risk adjusted returns. But what is clearly misunderstood by investors is the extent and content of these diversification strategies. An ideal diversification strategy involves having exposure to non or less-correlated asset classes in the portfolio. Also, required is the proportion of these assets to achieve a true diversification to the portfolio.

For instance, if a portfolio has 50 per cent equity, should one then diversify the risk by allocating the rest (50 per cent) into debt? While it may logically seem sound, it mayn’t result in higher returns if one is looking for them. So, the proportion of allocation to the various assets should be derived from the risk appetite of the investor so that it aligns with their goals and helps them negotiate a rough (equity) market or volatility of an asset class by having exposed to a less volatile one.

Diversification could be achieved by a varied strategy within an asset class. For instance, within equity, the large cap-oriented investments could have a relatively lower volatility than the small-cap stocks or funds. Also, the market cycles impact the performance of these stocks or funds. Hence, when certain businesses tend to do better and their stock, other mayn’t perform well enough. Thus, very rarely we find a secular growth or performance across the sectors, most of these tend to be at the end of the market cycle i.e., boom phase.

One could achieve a decent diversification within an asset, for example, in debt-oriented investments, one could have a high-yield bonds along with government securities. The former is highly volatile and sensitive to liquidity conditions, while the latter respond aggressively to any interest rate changes. The associated risks in these investments vary with the former is subjected to defaults, the latter are prone to duration risk.

While embarking on diversification, one must be wary of their perceptions. In most cases, investors tend to make decisions on what they believe is the risk and thus act to counter it. The reality, however, could be quite different from their perception. By embarking on such actions, investors could derive false comfort and make expensive errors of judgement resulting in debilitation losses.

Investors could also achieve diversification by allocating investments to their different needs as the nature and timelines of these needs vary. For instance, when one is planning for their children’s education needs, the allocation could be a combination of equity, insurance and debt. And when planning for retirement, with the timelines being longer than that of the education needs, the equity allocation could occupy a higher and debt could be negligible, at least at the beginning of the investment process. The debt allocation could be increased towards the proximity to need.

Sometimes, investors trying to achieve diversification make less than optimal allocations that wouldn’t serve the purpose. For example, if the education of the child is planned for overseas, the investment allocation to the need could have a higher exposure to foreign equity or related investments than that of the retirement need where it could be negligible or less. When allocating for education needs, investors needn’t explore foreign equity directly, but could utilize some of domestic funds with an exposure to foreign equity, if not the entirety of it. This would allow the investment within the risk tolerance of the investor. Similarly, if one were to plan for the marriage needs of the child, a decent allocation to gold directly or through financial form makes for good sense.

So, diversification is not a formula-driven rule, but investors could be better off by inculcating a bit of flexibility, while ensuring the allocations remain within their risk profile. An optimal diversification while generating better risk adjusted returns allow for an enhanced investing experience.

(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])