Portfolio Diversification

"Diversification is protection against Ignorance"

The fundamental reason for diversification is to minimize losses during the times of a bear market or when things don't really go as per plan. Diversification means allocating your funds into various asset classes in order to minimize the risk of your portfolio ( Don't put all your eggs in one basket!)

. Various asset classes where a retail investor can invest his money are: Equities, debt mutual funds, REIT's/Real Estate, PPF (Public Provident Fund) so on and so forth.

Majorly there are two types of risk: Systematic and unsystematic risk.

Systematic risk-

Variability in a security's total returns that are associated with overall movements in the economy is called systematic risk. For example: The Covid crisis, which is not in our control.

Unsystematic risk-

It is the component of price risk that is unique to particular events of the company and/or industry.

An investor can diversify his portfolio and eliminate unsystematic risk if not fully, partially by diversification into various asset classes.

If one is investing in asset classes that perform similarly- then this diversification is just name sake- and it never would give the hedge one expects from diversification. Investing in asset classes that demonstrate little or no correlation to one another may help you enhance diversification and reduce portfolio volatility. While diversification can neither ensure a profit nor eliminate the risk of experiencing investment losses, the ideal scenario is to have a mixture of non-correlated asset classes in an attempt to reduce overall portfolio volatility and generate more consistent returns over the long-term. Correlation varies between -1 to +1, +1 indicates full positive correlation and -1 is full negative correlation. Perfect positive or negative correlations are rare. Stay invested in assets that are negatively correlated to each other for benefits of diversification.

Examples of Negative and Positive Correlation:

At times, the concept of correlation can also be used smartly to invest in certain asset classes at the right time.

Exhibit : Indian Equity Markets, Brent Crude Oil and USD/INR.

The above chart shows the comparison chart between NIFTY50 and Brent Crude Oil.

Now why Brent Crude Oil and not WTI? Brent is the benchmark price used by Europe and Organization of Petroleum Exporting Companies (OPEC) while WTI is for US oil Prices. Since India primarily imports from OPEC countries BRENT is the right benchmark.

India being a net importer of crude oil. the price of it relatively matters a lot as most of the daily functions require crude oil or derivative of it and high crude oil prices is not good for our economy.

As we import 84% of our oil needs and the inelastic nature of its demand, an increase in crude prices invariably leads to higher import bills for the country in the short run.

Crude oil and it's domino effect:

• Higher crude prices leads to higher inflation for India. It has a direct impact on Wholesale Price Index (WPI) and Consumer Price Index (CPI). It also leads to high rates in petrol and diesel, again directly or indirectly affecting every other sector.

• Depreciation in value of rupee.

The Indian rupee continued to fall in value with respect to US Dollar. Touching highs of Rs. 80.21, this has been a added benefit to exporters and a disadvantage to importers. As money flows outside India the rupee dollar exchange rate gets impacted depreciating the rupee. The foreign portfolio outflows stood at Rs. 1.07 lakh crore in Q1F23 from equities.

All of this impacted the depreciating value of rupee.

I now expect it to stabilize at levels of 77.8-78.3

Different asset classes where one can invest:

1) REIT's- A Real Estate Investment Trust is a company that owns or finances income producing real estate, they provide investment opportunities to retail investors like a mutual fund.

The first REIT was introduced in India in 2019 and currently there are three REIT's in India.

• Mindspace Business Parks REIT Ltd.

• Embassy REIT Ltd.

• Brookfield India REIT

(Detailed blog on REIT's coming up)

These are available on well established brokerage firms such as Motilal Oswal, Zerodha so on and so forth. So if you have your demat account you can directly invest in them.

2) PPF (Public Provident Fund)-

Public Provident Fund is a long term investment scheme that provide good and most importantly stable returns. The prime target of opening a ppf account is safeguard of principle as it is regulated and a investment product introduced by the government.

Under Section 80C of the income tax act, the returns on maturity is Tax-Free!

Annually 7.1% returns are provided by PPF and is calculated on compounding basis.

• PPF has a lock in period of 15 years. Partial withdrawal is allowed after a tenure of 5 years.

• A minimum of Rs. 500 and a maximum of Rs. 1,50,000 can be invested in a PPF.

• Under Section 80C the principle amount and interest earned are completely tax free. So if you fall in the tax slab of 30%, and if you have invested in a PPF technically you make (7.1% + 30%*7.1= 9.23%).

3) Equity Mutual Funds- Equity mutual funds pool funds of investors and invest in the markets. Many renowned companies such as Parag Parikh Mutual Funds, HDFC AMC, Nippon India Mutual Fund have excellent track records in the past. Based on theme, sector, market cap you have a variety of mutual funds that one can invest in.

By Market Capitalization

• Large Cap

• Mid cap

• Small cap

• Large and Mid cap

By diversification

• Multi cap

• Focused

• Value Oriented

• International

By sector & themes

• High dividend yield

• Banking

• Technology

• Energy

• ESG

Above I have presented certain examples of mutual funds offered to the retail public.

4) Debt Mutual Funds- Debt funds are those that generate returns by lending your money to government and private companies. These invest in fixed income instruments such as corporate and government bonds, corporate debt securities and money market instruments. Certain advantages being they provide stable returns when compared to equities, government bonds are backed by the government providing a margin of safety when compared to privates companies that they would not default.

One recommended by many are GILT securities/funds, these mainly invest in government securities. These are low risk of non payment of interest.

"Diversification is for the know-nothing investor; it's not for the professional."

- Charlie Munger

Diversification is that one topic which is something not everyone follows, but everyone speaks. Many do not feel the need of it, but up to an extent yes it does benefit a retail investor.

If you do not belong to the field of finance or do not track the financial markets on a regular basis then diversification is a must.

On the contrary, if you are tracking your portfolio and your investments on a regular basis and your goal is not only to beat inflation but to make super normal returns also, then diversification plays a little benefit to you.

Shivam M. Dave