How to create an optimally diversified portfolio in a shape-shifting economic landscape
Authored by Raghvendra Nath, Managing Director, Ladderup Wealth Management Pvt Ltd
With equity markets trading at all-time highs, investors ought to balance their portfolio by appropriating capital towards a broad mix of investment categories and reducing unsystematic risk
Despite several macro-economic indicators pointing towards the looming threat of a global recession, the strong uptrend in both domestic and global equity markets show no signs of abating. At the same time, rising interest rates have made traditional fixed-income instruments like fixed deposits more attractive, with many listed companies offering even higher coupon rates on corporate bonds. To make matters even more confounding, both commercial and residential property prices across key Indian cities have been witnessing significant price appreciation in the post-COVID era, compelling many Indians to invest in real estate in spite of rising home loan rates.
Against this backdrop, investors ought to adopt a balanced approach when allocating their investible surplus and diversify their risk across different investment categories.
Remember the adage- Don’t put all eggs in one basket!
While many financial advisors recommend a larger capital allocation towards equities in your younger years, it is important to not go overboard with stock investments, especially considering the elevated valuations being commanded by most Indian equities. Following a 60/40 split between equities and fixed-income instruments has been long recommended, even though this depends entirely on one’s risk profile and near-term financial liabilities.
Investing in a mix of high-growth, high-dividend, value-oriented and cyclical stocks can prove to be more profitable in the long run, taking care to avoid significant exposure to one specific stock or industry. Similarly, for those who are risk-averse or wary of investing in the stock market, piling all your savings into fixed-income instruments should be strictly avoided as they offer little to no inflation-adjusted returns.
Avoiding over-diversification to mitigate unsystematic risk
Many investors hold the perception that risk can be reduced with each additional stock in one’s portfolio. This leads them to adopt an over-diversified equity allocation strategy, often placing bets on a single company across different industries, in a bid to reduce the unsystematic risk. However, there is strong evidence to suggest that such risk can be lowered to a certain threshold, beyond which no tangible benefit can be extracted from such a diversification strategy.
According to modern portfolio theory (MPT), which is a practical method for selecting investments so as to maximize returns with acceptable levels of risk, investors can achieve an optimally diversified equity portfolio by investing in about twenty stocks. In fact, the average standard deviation or risk of a single stock portfolio was 49.2 per cent, reducing to as low as 19.2 per cent when 1,000 different stocks are added to one’s portfolio. Nonetheless, one could achieve a standard deviation of 20 per cent by investing in just 20 stocks, achieving the same level of risk with a far less diversified equity portfolio. Obviously, it remains important to choose these stocks carefully, since overexposure to a particular group company or sector can cut into the return potential in the event of negative news flow.
Why dynamic asset allocation is the way forward
In a world where technological disruption has become increasingly common, there are many exciting asset classes and investment categories that could potentially return multi-fold returns over the medium term. Digital assets like cryptocurrencies and non-fungible tokens (NFTs) are some notable examples, having exploded in value over the past few years. However, timing can be crucial to avoid falling prey to short-term bear cycles and investors should act prudently when investing in such new-age asset classes.
Following a dynamic asset allocation strategy, wherein the asset allocation mix is adjusted based on prevalent market conditions, can yield far more rewarding risk-weighted returns. This has been amply demonstrated by many fund managers who follow the principle of buying low and selling high, alternating between equity or debt-heavy asset allocation to maximize returns on their investments. Adopting a similar approach while prudently experimenting with trending investment categories can be extremely beneficial for those with a balanced risk profile. However, this method requires considerable time and effort to be invested, proving more suitable for active investors with a deep understanding of how various asset classes perform during different economic cycles.
Investing in real estate for reduced volatility but stable long-term returns
Long considered by Indian investors to be the safest asset class for long-term investing, real estate offers the dual benefit of earning rental income along with long-term price appreciation. That said, the aspirational value associated with purchasing one’s own house, land or even commercial property can often lure investors into making irrational purchases. For investors looking to achieve an optimally diversified portfolio, investing in real estate is highly recommended as long as they are able to fund their purchase through savings or from the sale proceeds of another investment.
Resorting to housing loans is suggested only if the property is for self-consumption, replacing rental expenses with EMI payments. Moreover, scouting for real estate assets with a high rental yield is suggested, especially in upcoming Tier-II & III cities that could witness higher price appreciation. However, for those starting out in their investing journey, making an outright real estate purchase can still be a daunting task. Instead, allocating 10-15 per cent of one’s investment capital towards real estate investment trusts (REITs) that own income-generating real estate assets can be a more plausible option.
Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.