Both diversification and asset allocation are quite popular terms. Yet many of us don’t realize that we don’t understand these completely and they are usually used just to sell more financial products. In this article, I will be explaining both these concepts and how you can use them to have a better investment plan.
People while explaining, usually treat these concepts in two ways, either they use diversification and asset allocation interchangeably or they treat them completely unrelated concepts. Both ways are wrong, these two are related to each other but have a lot of differences too. They are both mainly risk management strategies which make use of investment instruments with different risk profile to achieve preferred risk level for the portfolio. Asset allocation if done properly provides the benefit of diversification but diversification is not the sole criterion for asset allocation. And diversification itself has to be viewed separately from asset allocation to best utilize it.
In this article, I will explain them both separately and give you effective methods to have the optimal benefit of both diversification and asset allocation.
Before we get into the topic of diversification it is important to understand the concept of correlation. As correlation is an important factor in understanding and implementing diversification.
What is Correlation?
Correlation is the measure of how much two assets are linearly related to each other. In simple terms, if two assets are perfectly correlated to each other they will always move in the same direction. If the value of one asset moves upward the value of the other asset also moves upwards and vice versa.
Correlation is measured by correlation coefficient (CC) which has a value ranging from -1 to +1.
- A CC of +1 means a perfect positive correlation, the assets will always move in the same direction.
- A CC of -1 means a perfect negative correlation, the assets will always move in the opposite direction. If the value of one asset moves upward the value of the other asset will move downward and vice versa.
- A CC of 0 means no correlation at all. The assets will never move at the same time either in the same or opposite direction.
Any value other then -1, +1, or 0 just shows the strength of the correlation. For example, two assets having 0.8 CC means they move in the same direction most of the time but not always.
This is a very simplistic explanation of correlation so that you may have a basic understanding of its effect on diversification.
Now that we have an understanding of correlation let’s get back to diversification.
What is Diversification?
Diversification is a method of risk reduction where instead of investing in a single instrument, the money is spread among multiple instruments. The benefit is that in case of one investment giving loss the overall portfolio will face less downfall.
The popular phrase “don’t put all your eggs in the same basket” is used to explain diversification. But the problem is that this simple explanation is mainly used to sell more and more products to people. This simplistic explanation is presented to a person and after every few months, a new product is sold.
Nobody discusses the genuine questions that should and probably do come in the mind of a genuine investor. Questions like
- How diversification affect the risk and return of a portfolio?
- When to use diversification?
- How much diversification should be there?
Let’s address these question and in turn, we can have a better understanding of diversification.
Effects of Diversification on Risk and Return
When people talk about diversification the conversation starts and ends with the statement, diversification reduces risk. Although this statement is true it does not represent the entire picture. Even if you buy stocks of every listed company the risk in your equity portfolio will not become zero. Diversification only reduces unsystematic risk, i.e. risk which is unique to a particular asset. Like risk unique to a particular company can be minimized by spreading the investment in stocks of different companies.
But if diversification can not make risk zero how much can it reduce the risk. Also apart from risk what happens to return due to diversification. Let’s understand it with an example.
We assume there are two assets to invest in, A and B. We use diversification to reduce our risk and invest in them in a 50:50 ratio. For our calculation let us consider returns are measured as absolute return and risk are measured by using standard deviation (SD). A gives a 10% return and B gives a 6% return. A has a standard deviation of 12 and B has a standard deviation of 2.
Whenever we invest in multiple instruments our return is always equal to the weighted average of the individual returns. So in our example, we can calculate the return by using the formulae.
PR = ((WA * RA)/100) + ((WB * RB)/100)
PR = Portfolio return
WA = Weight of asset A in percentage
WB = Weight of asset B in percentage
RA = Return of asset A in percentage
RB = Return of asset B in percentage
The return of our diversified portfolio comes out to be 8%.
But in case of risk, things change a bit. The risk is not equal to the average of the risk of individual components of the portfolio. The risk of a diversified portfolio depends on the correlation among the individual component. To understand this let us calculate the standard deviation of the overall portfolio with high positive correlation, high negative correlation, and zero correlation. We can use the following formulae
σP = (wA2σA2 + wB2 σB2 + 2wAwBσAσBρAB)1/2
σP = Portfolio standard deviation
WA = Weight of asset A in percentage / 100
WB = Weight of asset B in percentage / 100
σA = Standard deviation of asset A
σB = Standard deviation of asset B
ρAB = Correlation coefficient for both asset
For a high positive correlation we assume the correlation coefficient as +0.8, the portfolio SD comes out to be 6.83.
For zero correlation we assume the correlation coefficient as 0, the portfolio SD comes out to be 6.03.
For a high negative correlation we assume the correlation coefficient as -0.8, the portfolio SD comes out to be 5.23.
This shows that if we diversify our portfolio using assets that have a high positive correlation our risk reduction will be the least. In general, as the correlation moves from +1 to -1 the risk reduction increases.
To summarise, when we use diversification our return will always be equal to the weighted average of the individual returns. The risk reduction will depend upon the correlation, a high positive correlation provides low risk reduction and high negative correlation provides high risk reduction.
When to Use Diversification?
Too many times I have witnessed this scene being played. A sales guy approaches an individual, sales guy asks about current investment, sales guy preach about diversification, and the sales guy gets a commission by selling one more product.
This happens because many of us don’t have a clear idea about the conditions in which we should go after diversification. Diversifying our investments is not required all the time. Imagine a person investing money in RDs for a 3-year goal, the time period is short and all the investment is in a safe instrument. Should he diversify his investment into other types of assets like stocks or even bonds, NO.
Diversification comes into play when inflation and the limited amount available for investment, cause us to invest in risky assets like equity and gold. As most of us don’t have large sums of money and we need to beat the inflation we have to invest in risky assets, and in such cases, we should minimize the risk and diversification is one such way.
How much risky assets you can and should invest in will be discussed under Asset Allocation.
How to Implement Diversification Efficiently?
If you need to diversify, a practical and efficient guide for implementing diversification will also help you answer the question of, how much diversification you should have. This is not the only way but as always I will be explaining what I personally do in my portfolio. You need to implement diversification at two-level, diversification among different asset classes, and diversification within each asset class you have invested in.
Diversification Among Different Asset Classes
There are some asset classes to which different investment instruments belong to. The major asset classes are following
- Real Asset
These asset classes have a low correlation to each other and in many cases even negative correlation. Further, the risk and return profile of these asset classes vary from each other a lot. This makes diversifying among two or more asset classes very beneficial from a diversification point of view. You have options with different risk levels and low correlation, if you invest in them you can achieve maximum risk reduction.
Investing in debt and equity is the most effective option, and it is the minimum diversification you should have at this level. This is what I have implemented. The maximum diversification will differ from person to person, for me gold/silver is even more volatile than equity and are more emotion-driven. Real estate is going through stagnation and I don’t think it will start showing movement any time sooner. Thus I stay away from both of these. A simple equity plus debt portfolio can fulfill your need efficiently.
This is dealt when you consider asset allocation, and will be covered under it.
Diversification Within an Asset Class
Once you have diversified your investment among different asset classes, a major portion of unsystematic risk is reduced, i.e. unique risk belonging to all instruments belonging to one asset class. But further diversification within an asset class can still reduce your risk with a significant margin. Within an asset class, you will find that the correlation is mostly positive and not very low, but still, you can diversify among different sectors in equity or among different types of bonds in the debt section. These won’t have a very low correlation most of the time but under some conditions, one might show movement in the opposite direction than the overall market. For example the pharma sector in 2020, this is very hard to predict and thus diversification among 4 to 5 categories will also be beneficial for risk reduction.
Even this is somewhat based on the correlation factor, but what happens when you are talking about a single category within an asset class. Now you are bound to have a quite high correlation, again consider pharma sector companies, investment in these companies is bound to have a high correlation. But still by diversifying in stocks of more than one company you can reduce unsystematic risk like one of the companies facing financial troubles due to mismanagement. Investing in 2 3 instruments belonging to the same category of same asset class also reduces risk with a substantial margin.
So the way to implement diversification efficiently is to diversify among at least two asset classes and not more than the four major ones. In each asset class diversify among 4 to 5 different types, like different sectors in equity, etc. In each category diversify among 2 to 3, like diff companies of the same sector, etc. Any further diversification might not reduce risk in a major way but will definitely increase efforts required to manage the portfolio and will affect the returns.
As I invest in equity and debt I can give the most effective way to have the benefit of diversification, without complicating your portfolio.
- Equity: A NIFTY 50 or SENSEX Index fund is enough, any more diversification would not provide much risk reduction. If you don’t want to invest in mutual funds, 30 to 40 stocks of different sectors from NIFTY 100 are enough.
- Debt: FDs/RDs, Provident funds, one liquid fund, is more than enough. If you don’t want to invest in mutual funds then bank and post office deposits, Provident funds, and small saving schemes are enough. Any more diversification will not provide much risk reduction.
Asset allocation is a strategy that uses different risk and return profiles of various asset classes to achieve a desirable balance of risk and return. Asset allocation is a very important factor when it comes to investment planning for an individual. Although asset allocation provides a major diversification in the portfolio, diversification is not a factor based on which asset allocation is determined.
Asset allocation in the simplest term is a two-step process. In the first step, you determine which asset classes you want to invest in. In the second step, you determine the proportion in which you should invest in the asset classes you have decided on. The asset classes you decide to invest in must always have two types of asset classes, low risk low return asset class like debt, and high risk high reward asset class like equity.
Selecting the Assets to Invest In
Deciding the asset classes which will be part of our portfolio is a major decision in investment planning. The first asset class you will need is a low-risk asset class as this will work as a foundation for your entire portfolio, the debt asset class can fulfill this criterion. Secondly, you will need an asset class that can provide inflation-beating returns, remember any such asset will come with significantly higher risk, equity asset can fulfill this criterion. A simple portfolio comprising just these two asset classes can fulfill your investment requirements easily. You can add more asset classes if it fulfills the following condition.
- If you have enough knowledge of that asset class that you can establish the returns it can provide and the risk it has.
- If you are certain that the asset class can either provide good returns or low risk you can use it in your portfolio.
If you cannot determine the risk and return of that asset class, or if that asset class cannot provide either high returns or low risk, stay away from it.
It doesn’t mean that you should run after every asset class that has given high returns in the recent past. Like gold, which has been stagnant for so many years and showed upward movements in 2020. Remember the first criterion is you should have knowledge of that asset, many people use gold for investment but they know how much risk they are taking and how much return they can get. You should only invest in those instruments about which you have a clear idea of risk and return.
In my case take the example of the gold asset class. I don’t have substantial knowledge about this asset class, and the limited knowledge I have just give me the idea of this being a high-risk asset class. Due to my limited knowledge, I cannot determine what return I can expect from it. So I stay away from it.
Now take the example of the real estate asset class, due to my previous work experience I have ample knowledge about the ground situation in the real estate market. Based on that I think this asset class has high risk but not enough return potential. So I stay away from it.
If you have any confusion just stick to debt and equity asset class, you won’t lose anything.
Determining the Proportion of Different Assets (Asset Allocation)
As I only invest in equity and debt so I will be writing about them only. You can apply the concept to other assets accordingly.
The determination of the proportion of various asset classes is determined by the following factors.
- The time period of your investment, i.e. how far is your goal.
- Effect of inflation, which will depend on the time period.
- Your investment capability, i.e. how much money you can invest for that goal.
- The importance of the goal, child education, and retirement are examples of very important goals.
Let’s look at goals of different time periods and determine the asset allocation.
Goals of 0 to 5 year
The time period is short, thus if we invest in risky asset we might not get time to wait for recovery from a crash. Also, the effect of inflation will not be that much and a small increase in our investment can overcome inflation. So neither we need risky assets nor we can afford them. These two factors alone are enough to determine that for goals up to five years no risky asset is needed.
So for goals of 0 to 5 years term 100% investment in debt assets.
FD/RD for up to 3 years, as they have very low risk and debt mutual fund provides no tax benefit. For 3+ to 5 years safer debt funds like liquid funds can be used as they will provide a tax benefit.
Goals of 5+ to 10 years
Beyond 7 years inflation start having a major impact on your investments. But at the same time, you have a bit more room for a risky product as you have a bit more time. For goals up to 7 years, if you can increase your investment to combat the effect of inflation, I would suggest you do that for important goals. For goals of 7+ years, the increase in investment might come out a bit much thus exposure to a risky asset can be opted for.
I recommend a maximum of 40 to 50% exposure to a risky asset like equity. Remember this is the maximum, 40% for important goals, and 50% for others. If you can increase the investment you should definitely do that and reduce the exposure to risky assets.
So for goals of 5+ to 10 years, maximum equity exposure can be 40% for important goals and 50% for other goals and rest in debt assets.
Goals of 10+ to 15 years
For these goals the inflation becomes a major issue, it is not practically possible for most investors to increase investment to combat inflation. Investing in risky assets cannot be avoided, but still, if you can increase the investment and reduce the exposure to a risky asset you should definitely do that. But at the same time as our time period is long, we can take a bit more risk.
So for goals of 10+ to 15 years, maximum equity exposure can be 50% for important goals and 60% for other goals and rest in debt assets.
As was with the previous category, same with this, this is the maximum equity exposure. If you are investing enough amount that you can reach your goal with lower equity exposure, no need to have higher equity exposure.
Goals of 15+ Year
Inflation is a major concern while planning for goals with such a long time period. Higher exposure to risky assets cannot be avoided for goals of this duration. But this long duration also gives us more time for our risky assets to recover from downfalls. Mostly these long term goals are high priority like retirement or child-related goals. All these factors have to be taken into consideration.
We might need more risky asset and we might be able to handle more risk, but priority is also very high. Thus too much exposure to risky asset can ruin your investment of such long duration.
So for goals of 15+ years, maximum equity exposure can be 60% and rest in debt assets.
Determining asset allocation is a very important decision for your investment planning, but without rebalancing and decreasing equity exposure as you approach your goal, it will not give the desired benefits. Both of these will be covered in my next article on rebalancing.