Portfolio Diversification Works Best During Volatility

If ever there was a time that underscored the efficacy of building a diversified portfolio, it would be now. Stock prices are all over the place, as market participants unsuccessfully respond to the impact of COVID 19 on the world economy and its stock markets. I say “unsuccessfully” only because this is an evolving situation and the extent of its impact on economic growth and stability is uncertain. While the impact is not easily measurable, it is for sure that businesses are facing a recession of sorts in the near future. In an attempt to help businesses stay afloat in these turbulent times, certain Central Banks’ across the globe have reduced interest rates. In response to a fall in interest rates, bond prices have been going up. So, in the current scenario, while equity prices are going down, bond prices are going up. An investor who is disproportionately skewed towards equities would definitely be feeling the burn right now. On the other hand, investors who have created well-diversified portfolios that are spread across equity and fixed income instruments are likely to emerge relatively unscathed from the current turmoil. This makes a strong case for portfolio diversification.

What is portfolio diversification?

Portfolio diversification is basically a portfolio construction strategy that requires an investor to invest in a mix of multiple asset classes in an attempt to mitigate overall portfolio risk. It basically means that you spread your portfolio exposure across multiple asset classes and investment instruments such as your exposure to any one-asset class do not have a disproportionate impact on the overall performance of your portfolio.

Why build a diversified portfolio?

Portfolio diversification is primarily used as a risk mitigation tool. Traditionally, it has been observed that different asset classes respond differently to particular events and macro-economic developments. Generally, the correlation between various asset classes ranges from -1 to +1. Thus, assets that have a low or negative correlation with each other will not respond in a similar manner to a specific development. This will help in mitigating portfolio risk as a fall in one asset class might potentially be offset by an increase in another asset class in your portfolio. Case in point is the current environment where equity prices are falling but bond prices are increasing.
In order to mitigate portfolio risk, investors should create a portfolio comprising an optimal mix of stocks, bonds, alternate investment, and cash. This will ensure that the downside is protected in negative markets, thereby preserving the portfolio from high capital losses.