Why and How to Diversify Your Portfolio?

Investing in an all-equity portfolio may seem logical when the stock market is showing double-digit returns. However, equity markets do not rise in a straight line. The returns on the Nifty 500 index over five years reflect results at a single point in time. Stock markets have experienced corrections during these five years. A 100% equity portfolio would, therefore, experience the full impact of such corrections. On the other hand, a lower equity allocation would result in more minor corrections.

The Importance of Diversification

Case Study: 2015

The stock market began 2015 strongly but then declined.
The Nifty 100 index fell by 2.5%, and large-cap funds lost 0.37%.
A portfolio composed entirely of equity would have mirrored this decline.
Adding 20% debt to the portfolio would have led to a 1.1% rise in 2015 instead of a loss.
In 2016, the same principle applied, with a combined portfolio yielding 5.2% versus 3.5% for pure equity.

Why Diversify?

Diversification spreads the risk across different assets and investment styles, reducing the impact of market volatility.

Types of Risks to Consider

Asset Class Risk: A portfolio entirely composed of equity will produce varying returns over time. Introducing debt can reduce the overall risk. For example, a 70/30 mix between the BSE 100 index and the CRISIL bonds fund over 10 years would have provided higher returns with lower volatility, especially during market corrections like in 2008 and 2011.

Fund Style Risk: Holding multiple funds with similar strategies doesn’t add much value. Funds vary in their approach—some focus on growth, others on value, and some are more diversified. Mixing these styles can help balance performance across different market cycles.

Diversifying Across Asset Classes

Your investment timeframe will determine the first level of asset allocation between equity, debt, and possibly gold.

Long-Term Horizon (Over 4 Years):
- High-Risk Investors: 80% equity allocation.
- Moderate-Risk Investors: 60-70% equity allocation.
- Conservative Investors: Lower equity allocation to avoid long-term losses.
Shorter Timeframes: Even high-risk investors should avoid heavy equity allocations for shorter timeframes. Since 2007, the Nifty index has shown losses over 20% of the time in rolling two-year periods.

Diversifying Across Categories and Funds

Adjusting the portfolio mix within asset classes can alter risk-return dynamics.

Large-Cap and Balanced Funds: Diversification within these categories is often unnecessary. Most large-cap funds focus on the top 100 stocks. If holding multiple large-cap funds, consider mixing investing styles to avoid redundancy.
Balanced Funds: Ideal for conservative investors, balanced funds typically adhere to a 70:30 equity-debt ratio and adjust market capitalisations accordingly.
Diversified Funds: These funds can serve multiple roles in a portfolio. Some focus on large caps, while others offer a broader investment approach, making them suitable for moderate to high-risk investors.
Mid-Cap Funds: Avoid over-allocation to mid-caps, as the universe of investible stocks is small and can overlap across funds. A maximum of 25%-30% allocation is recommended even for high-risk investors.
Debt Funds: Align debt funds with your investment timeframe. For short durations (less than two years), stick to ultra-short-term and short-term funds. For longer durations, consider a mix of dynamic bond and income accrual funds.
International Funds: These can provide additional diversification but choose markets that do not correlate closely with Indian markets, such as Europe and the United States. Limit international exposure to 10% of your overall portfolio.

Investing Behavior and the Need for Diversification

Beyond managing market risks, diversification helps mitigate behavioural risks:

Long-Term Investors: Even with a long-term outlook, you might need to withdraw funds in the short term. Diversification helps reduce the impact of market corrections on your portfolio.
Risk Tolerance: You may consider yourself a high-risk investor, but seeing your 100% equity portfolio decline during a correction might lead to panic. Diversification can help manage this risk.
Value Investing: You may identify as a value investor but struggle to hold onto underperforming funds. A diversified portfolio helps you stay invested through market cycles.

Conclusion

Diversification is crucial for managing both market and behavioural risks. A well-diversified portfolio, with attention to avoiding portfolio overlap, helps you stay invested, protect profits, and reduce stress during market downturns. It is less about the number of funds and more about selecting the right types of assets and funds.