Dividing an investment portfolio into different asset classes such as equity, fixed income and physical assets, if any, has been the foundation of investment planning. The idea is to reduce the overall risk of your investments, as different asset classes perform differently in different market phase. Of late, however, it has been observed that the correlation of returns among various asset classes has increased. Nevertheless, the importance of right asset allocation cannot be undermined and it will continue to help investors during market turmoil.

One of the reasons why a diversified portfolio performs better than the concentrated portfolio, in the long run, is because a diversified portfolio declines less in value during market turmoil. Hence, a diversified portfolio recoups its losses faster than an undiversified portfolio. For example, a portfolio that falls in value by 33% must grow by 50% to recover its loss, but a portfolio that declines by 25% only needs to grow by 33% to fully recover.

The current elevated level of correlation among different asset classes has not reduced the importance of asset diversification, but it has only increased the level of detailing to reduce the correlations. Hence, if earlier equity was considered as one asset class, it needs to be further sub-divided into small, large and mid-cap stocks. Likewise, bonds can be further categorised into treasuries, corporate bonds, etc.

For example, investments with a correlation of 0.5 provide greater diversification benefits than those with a correlation of 0.7 and the benefits of diversification increase as the correlation decreases.

How to build a diversified portfolio

Before building your portfolio, you first need to understand the objective of your investment. Your objective can vary from buying a house or car to a foreign trip, or it can be purely to maximise your gain on investments. Once you have established your objective, you need to zero down on the assets to form part of your portfolio. The only consideration you need to have while choosing your asset classes is that the minimum the correlation between them, the better will be your portfolio attributes. The various asset classes that can be part of the portfolio are equity (small, mid and large-cap), bonds (treasuries as well as corporate bonds), commodities (gold and other precious metals) and cash & investments.

The above asset classes can form part of your portfolio and the right mix will again depend on your investment objective and risk-taking ability.  Once a strategic asset allocation is in place, you should frequently review it to take advantage of market opportunities or to avoid risks in certain segments of the market.