Diversification
DIVERSIFICATION is the buzz word in investing world. This word connotes different meaning to different investors. What are different ways of diversifications and what diversification can add value to an investor’s portfolio:
Market Cap Diversification:
Investors invest in different market caps like Large Cap, Mid Cap and Small Caps and feel they have diversified their portfolios. However, Recency Bias makes their portfolios tilt more towards segments which have done well in the recent past like currently, Mid Caps and Small Caps have done exceedingly well over Large Caps over past few years. This makes investor portfolios very heavy in Mid & Small Caps at current juncture of extreme high valuations. Unfortunate part of this is that as and when markets have corrected or had major drawdowns, this segment of Mid & Small Caps have had accentuated mark downs v/s Large Caps. Recent examples are 2018 to 2020 COVID corrections and 2008-09 corrections due to Global Financial Crisis. Also, all funds are in one asset class only viz. EQUITY. Investors must be careful in thinking that they have diversified their portfolios by investing in different market cap buckets based on this definition of DVERSIFICATION. In fact, it will act counterproductive during market drawdowns due to the fact their portfolios are heavy in Mid & Small Caps.
Sector Diversification:
Many invest in different sectors and believe their portfolio is well diversified. This requires expertise to be nimble footed and manage sector rotations as and when one sector becomes expensive and others underperform and vice versa. This is easier said than done as again RECENCY BIAS makes investors invest in sectors which have performed extremely well in the recent past and ignore those sectors which have not done well. Case in point is investing in sectors like Defence, PSUs, which have done well over past few years. Post looking at past performance, then investing in these sectors, investors realize (the hard way) that they invested at wrong valuations and their portfolios started bleeding due to this. Sectors which had not participated in recent bull run were Banking, Financials & IT. These were not finding investor fancy as FIIs were sellers from these sectors due to over ownership and lower weightage in the MSCI EM Index. Post rate cuts, FIIs have come into Indian markets with a vengeance. This will benefit some of these sectors which will have a higher weightage in the Index, being in Large Cap space (where FII flows generally happen) and have a re-rating of these sectors. However, even in this case, there is concentration on portfolio in one asset class viz. EQUITY.
Diversification based on number of stocks held:
Investors are known to invest in too many stocks and believe that they have diversified their portfolios. For each stock to add meaningful alpha in their wealth creation quest, they need to be of decent allocation of the overall portfolio. This needs lot of conviction by investors in the stocks they invest in. Most investors invest based on tips and hearsay. Hence, they can never have conviction of taking concentrated bets – which makes their portfolios underperform as half of their investments lack research and convictions. Again, this diversification is only in the same asset class viz. EQUITY.
Diversification in real estate and jewellery:
Most investors have invested, besides Equity some portion of their portfolio in real estate and buying jewellery. If they consider real estate where they are staying and jewellery they have purchased for their family as investment diversification, it will be a wrong assumption of diversification of portfolio. Reason being, house which the investors are using as their primary home or jewellery they have bought for their family, they have emotional attachment to both these investments and consider it as taboo to sell the same in bad times. Of course, in extreme circumstances, both will have some value and can be monetized, if need be, but it seldomly happens due to social taboos and compulsions. Unless, an investor has purchased real estate (residential or commercial) for the purpose of renting and generating rental incomes thereof, primary homes should be kept out of definition of diversification.
Geographical Diversification and Currency Diversification:
An investor can invest in different geographies and different currencies to diversify their portfolios. However, their HOME BIAS or COMFORT ZONE BIAS does not let them diversify into different geographies. They are comfortable investing in their own countries as they are familiar with their markets. Also, regulatory restrictions (like current embargo on further investments in equities outside India by RBI) also does not let investors diversify into different countries and different currencies effectively.
Then what is true diversification and what is the purpose of diversification?
True diversification and its purpose are to invest in negatively correlated asset classes which counter balance each other during times of volatility in any of the asset classes. Some may have positive correlation and some may have negative correlations, but as a combined portfolio, it should be able to weather storms under different weather conditions and come out on top. For example, equity is supposed to do well in expansionary economies and debt & gold are supposed to do well in contractionary economies. Also, gold, or precious metals become a good hedge not only against inflation but also during uncertain and chaotic geo-political scenarios. Investors only think of some of these asset classes like Equity, Real Estate, Gold as some of the asset classes for portfolio diversification. But one of the main asset classes which gets missed out in this allocation is CASH or DEBT as an asset class – dry powder to take advantage of market volatility in other asset classes.
Importance of CASH in a portfolio Diversification:
It is important to understand the role of CASH or DEBT in an investor’s portfolio. Most investors stay fully invested even when market valuations are expensive or stretched. This is a dangerous situation when markets go into major drawdowns and investors’ hands are tied behind their back and they can only witness carnage in their portfolios as a) they do not have the guts to invest further or b) they do not have any additional funds to deploy when opportunities arise as they were fully invested before that.
Investors need to apply 80:20 rule in their portfolios. To maintain their health, they need to eat up to 80% of their needs. Leave 20% of hunger unfulfilled. Similarly, to maintain wealth, participate up to 80% of market upside. Let go of some up side to avoid future regret as one does not know when markets have peaked and when drawdowns will occur going forward. This, then creates margin of safety in your portfolios and creates some cash balances. Remember, Warren Buffett is sitting on almost $300 bln in cash in Berkshire Hathway portfolio. Just because you have funds to deploy, does not mean that you invest all funds at any valuations. As they say, CASH IS KING when market valuations become expensive or stretched. Investors will need to show a lot of patience, let go of their GREED and not have FOMO when they have created margin of safety in their portfolios. Markets will give an opportunity to deploy funds at an opportune time. Real wealth creation can happen, not by investing at expensive valuations in the markets during Bull run, but real wealth can be created only when one invests in bear markets (when others may be exiting). In fact, by investing at expensive valuations in Bull Markets, an investor needs to tone down their future return’s expectations. Returns in NIFTY 50 from January 2008 to September 2024 is just 9% CAGR. 10 year returns from January 2008 was only 5.31%- and 15-year return was only 7.47%. Despite holding for such a long period of 16+ years, equity has delivered only 9% returns, reason being in January 2008 NIFTY 50 valuations were very expensive at 29 PE and 6.5 PB.
To conclude:
True DIVERSIFICATION is by investing in different asset classes, different geographies which are negatively correlated but also add some margin of safety through generation of CASH when valuations become stretched without resorting to GREED or having FOMO.
Equity (domestic + international) – does well in expansionary economies
Gold – does well in contractionary economies and acts as a hedge against inflation
Real Estate – not primary homes but if invested for generating additional cash flows through rental income and capital appreciation – only when rental yields are reasonable and high does it make sense to invest in 2nd or 3rd properties and can generate decent capital appreciation
Cash – adds margin of safety in portfolios (especially when market valuations are overstretched in other asset classes and can be used to capture opportunities of investing at better valuations)