Factor-based investing to diversify your portfolio

The recent volatility in the equity market has once again highlighted the importance of diversification in one’s investments. This helps you to keep your portfolio on an even footing so that when market wobbles your portfolio risk is minimised. Diversification, in the traditional sense, is understood as some mix of stocks, which might be from different sectors or from the same sector with a different market cap or in some cases mix of stocks and bonds. These stocks and bonds are not likely to move in tandem, however, worst fears come true when the market falls, and your portfolio too falls, probably with a larger percentage. The reason being the performance of any asset class is determined by certain factors, which if remains same in your entire investment, it is likely to impact your returns adversely. Such diversification is better known as DINO-diversification in name only.

Nevertheless, factor-based investing might solve some of such problems of traditional diversification. A ‘factor’ in simple terms means something which cannot be divided further. For example, a figure like inflation cannot be further decomposed, while it is only one of the factors that are used to analyse bonds along with GDP number, interest rate, convexity and duration. When we speak of factors in equity investments some of the common factors are market-cap, value, size, momentum and low volatility.

A factor-based investing strategy involves integrating various factor exposure into your portfolio. Each factor has its own risk and returns characteristics. Hence as an investor, you need to understand these characteristics and identify those that suits your risk-return expectation. Beside these factors even have cyclicality, which means they perform in cycles that is there is no evergreen factor that will always help you generate positive returns. Such understanding will help you in proper asset allocation and most importantly rebalancing your portfolio at an appropriate time.