Diversification of investment is not in numbers

For goal-based portfolios, bond investments should typically be in bank FDs, PPF and tax-free bonds.

For goal-based portfolios, bond investments should typically be in bank FDs, PPF and tax-free bonds.   | Photo Credit: Getty Images/iStock

Adopt a mix of bonds, and assets whose returns could be higher than expected

We all like to diversify our investments. We spread our fixed deposits among three or four banks as we believe that the likelihood of all these banks failing to repay our deposits at maturity is low. Using the same logic, we also invest in several equity funds. However, investing in multiple investment products may not, necessarily, reduce investment risk.

Portfolio diversification

Suppose you invest in five different equity funds to diversify your investment risk. What if all of them have large holdings in the same stocks, say, Reliance Industries and HDFC Bank? If these stocks decline sharply, so will the net asset value (NAV) of all these funds. So, investing across multiple funds may not necessarily prevent your investments from declining in value.

Correlation is vital

Diversification is not about spreading your investment across multiple products. It is about how each of these investment products correlate with (or relate to) each other. Ideally, you want your equity investment products to increase in value when the market moves up.

On the flip side, you want some of these investment products to move up when other products in your portfolio move down in line with the market.

But, gathering such products to form a portfolio requires application of rigorous statistical and mathematical tools. This is because you have to determine how these products relate to each other when markets move up as well as when they drop. Now, most investors cannot engage in such exercise for want of time and effort. So, what should you do? Stop buying multiple investment products.

It will save you from the ordeal of managing a bulky portfolio. Also, you will not draw false comfort that you have reduced your investment risk. That said, you should draw comfort from the fact that you are already reducing risk through your asset allocation process. This involves allocating your investments across assets such as equity and commodities. You should preferably use two assets in your goal-based portfolios — one that offers higher-than-expected return and the other that provides stable cash flows.

Buying a home

Assume you want to buy a house ten years hence and decide to invest in equity and bonds. By bonds, we mean any interest-bearing instrument offering you stable cash flows, and a pre-defined value at maturity. It is easier to map cash flows from bonds to the cash flows needed to achieve your goals. For goal-based portfolios, bond investments should typically be in bank deposits, public provident fund and tax-free bonds. They must preferably pay interest at maturity, not annually. So, if you are investing to accumulate money to finance your vacation three years hence, you should invest in a three-year recurring bank deposit (RD). Your equity investments will be in mutual funds, preferably a Nifty Index fund.

Now, your bond investments will provide stability to your portfolio because of the known cash flows at maturity. But bonds offer low post-tax returns because of higher tax rate and lower-than-expected return, and do not beat inflation.

Hence, you need equity investments. While equity offers higher-than- expected return, the cash flow you will receive when you sell your equity investments is uncertain. Diversification is, therefore, all about how judiciously you mix a higher-than-expected-return asset (equity) with a stable-return asset (bonds). We believe it is best you pay greater attention to your asset allocation — the proportion of equity and bonds in each of your goal-based portfolios. Often, investing in one RD and in one index fund will suffice to achieving a goal.

(The author offers investor-learning solutions)

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Printable version | Mar 31, 2020 8:09:10 PM |

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