Create a mix of assets that would yield superior risk-adjusted returns over the long term
Global economies are propelling towards recovery after a year of unforeseen changes due to the pandemic and subsequent economic repercussions. 2021 has had a momentous start with Covid-19 vaccines on their way and it might be an interesting time for investors to assess their existing and forthcoming finances for a brighter financial outlook. Now is more important than ever to create diversified portfolios and understand the value of risk management in financial planning.
What Is Diversification?
Diversification is an investment strategy aimed towards managing risks by spreading money across a variety of investment options such as fixed deposits, stocks, bonds, real estate, cash alternatives, among many other tools. The core philosophy behind portfolio diversification is quite simply to “not put all eggs in one basket”. The rationale behind a diverse portfolio is to create a mix of assets that would yield superior risk-adjusted returns over the long term.
A simple example of diversification - let us consider a vendor who sits next to an office complex. He sells both umbrellas and sunglasses by the road. Initially, it may seem unlikely that he will make sales of both products every day. However, whenever it rains unexpectedly, workers of the offices nearby are likely to pick up an umbrella to reach their homes. On another sunny hot day, they may choose to buy sunglasses. By selling both items, he is diversifying the product line, thereby reducing his risk of losing money on a given day.
Diversification in several categories enables investors to offset a loss in any one investment by avoiding over-exposure. Similarly, it also allows investors to ride out market volatilities by providing a steadier exposure in various economic conditions.
Why is diversification important this year?
By creating a well-diversified portfolio, investors can try to contain an element of risk in their investments while allowing for the possibility for growth. This balancing act between risk and growth becomes even more important given the volatility that we have seen in the last year. Proper asset allocation, across a mix of global assets, positions your portfolio better to deal with such volatility in the future.
Avenues for diversification Diversification can be achieved through asset classes and geographies. Global or international diversification of portfolio implies selecting stocks and other assets that focus on foreign markets. A well-designed portfolio gives the investor exposure to developed and emerging markets, enabling diversification of the portfolio. International diversification primarily means exposure to sectors and asset classes outside the Indian markets, making the portfolio more holistic. For the Indian investor, this means protection against India-specific risks and isolated shocks in the Indian markets. A few ways to provide exposure to overseas securities include the purchase of US ETFs, mutual funds, and stocks.
Mitigating risks with global exposure
A simple rationale behind international diversification is to mitigate investment risk. Also, during this interconnected era, it is difficult to avoid international exposure. A diverse portfolio can help in managing volatility over a period and may surpass a concentrated portfolio in the long run. Smart international diversification helps in absorbing losses of one asset class by weighing it with the gains of others. Diversification in asset classes like commodities is easier overseas. Global diversification also helps save in foreign currencies for longer-term opportunities in alternative asset classes like real estate and for specific requirements like overseas education, thus mitigating potential foreign exchange risk. Therefore, it becomes vital to choose a combination of investments that meets the investors’ long-term investment objectives and fits their risk tolerance.
Let us have a brief look at the overall portfolio construction approach incorporating asset allocation and diversification:
Identifying goals: The fundamental question and the starting point of every investment decision is the underlying goal behind making investments. For many investors, the priority lies in securing a steady income, providing for children’s educational needs, and setting up a safety net for the family’s future financial requirements. Portfolio management requirements may differ for all and might change with any alterations in financial goals. Thus, establishing strategic objectives to manage the portfolio becomes imperative.
Asset allocation: This is the second and one of the most important factors in a well-balanced portfolio. Most investors question why there is a need to include various asset classes when the focus can be on one individual class basis an individual’s objectives. Asset allocation is dividing a portfolio into several categories such as bonds, stocks, and cash. Asset allocation, or choosing the right mix, is an individual decision and may vary for all. By investing in multiple asset classes, investors can reduce the risk of loss and increase the chances of higher returns on investments. For instance, if one asset category fails to yield expected returns, the same can be balanced by better returns from another category.
Diversification: Even though choosing asset classes basis their functions is extremely important, diversifying a portfolio helps in mitigating the risks of losses. Also, choosing assets that have lower correlation is important for reducing the overall risk of the portfolio. Diversification does not imply that one invests in 10 different tech stocks, it means branching out to various industries and asset classes. Global investing has gained considerable momentum in the past few years. Individual investors should try their hand at investing in global securities; this would help them to gain international exposure and to reduce correlation risk in their portfolio.
Rebalancing periodic asset allocation: This becomes necessary over a period when assets do not align with an investor’s investment goals. By rebalancing a portfolio, one can ensure that their asset allocation remains in line with their investment plan and none of the asset categories in the portfolio become significantly overweight or underweight as compared to the original plan.
Evaluate new goals and review asset allocation: In a normal scenario, this is done when you are closer to your investment goals. For instance, a person investing to save for retirement might hold fewer stocks and more bonds or cash equivalents, as they get closer to their retirement age. But the ongoing pandemic has led to drastic changes in the financial situation of people leading to a change in financial goals, risk tolerance, and risk appetite. Therefore, the change in asset allocation becomes essential.
In conclusion, investors should consider investing globally in 2021 to build a diversified portfolio that reduces their risk. With international companies continuing to benefit from global growth and participating in emerging themes such as artificial intelligence and clean energy, investors that create a well-balanced, diversified portfolio can have the dual benefit of reducing their overall portfolio risk while building exposure to these growth stories. Now is the time to make prudent decisions for long-term wealth creation.
The author is Co-Founder and CEO - Globalise
DISCLAIMER: Views expressed are the authors' own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.