How to diversify your investment portfolio

Traditional wisdom says don’t put all your eggs in one basket. It restricts the damage to your financial well-being in
case one asset class or instrument goes for a tailspin. For example, equities crashed by 39% during 2008-9. If you
had a goal maturing that year and were depending largely on stock investments, it would have been a disaster.

However, if you had spread your investments across equity, debt, cash and gold, the portfolio would have given an
average return of 0.68% ( see graphic). This is because of the stellar performance by gold (up 24%) and stable
returns from debt and cash during that year. The situation reversed the next year, with equities rising 94% and all
other asset classes giving lacklustre returns. Even so, the diversified portfolio managed to generate 27% returns that
year.

Not all investing stories have happy endings though. Some may think that diversification led to lower returns in
2009-10. Instead of earning 27% from an equally weighted portfolio they could have earned 94% from equities. But
this is based on hindsight. In the real world, most equity investors would have panicked and withdrawn from the
market in 2008-9, when equities had crashed by 39%. “Those who held on during the difficult periods of 2008-9
would have made money, but most would not have because genetically humans are risk averse and react to crisis
situations,” says Kunal Bajaj, Founder and CEO, Clearfunds.

Purpose of diversification
The basic objective of diversification is to reduce risk. But can’t one do that by investing only in ultra-safe
government schemes such as PPF, NSCs and RBI bonds? No, because investing in these instruments will reduce the
overall returns significantly. “Investing 100% in debt options won’t help meet future needs. Investors should have
some growth oriented assets such as equities to increase returns,” says Rahul Agarwal, Director, Wealth Discovery.
Besides lower returns, the income from debt products attracts higher tax rates. “Interest is taxable for most debt
instruments, so the post-tax return will be very low and won’t beat consumer inflation,” says Amol Joshi, Founder,
Plan Rupee Investment Services. Investors may have to forgo several of their financial goals if they follow this risk-
free strategy.

Though everyone would love to earn high returns without taking any risk, in real life one has to manage risk and
return together. “What investors should aim is for decent returns with reasonable level of risk,” says Shailendra
Kumar, CIO, Narnolia Financial Advisors. The best way to do this is by following a disciplined asset allocation
strategy.

Ideal asset allocation for you

Though there are thumb rules, the asset allocation should be based on individual needs. Here are a few things to
keep in mind when determining the asset allocation of your portfolio.

Current asset allocation: As a first step, investors need to understand where they stand. Many aggressive investors,
who claim that they have invested 100% in equities may not be aware of the real situation.

“There is no investor who has put 100% in equities. People who say that usually mean that 100% of their liquid
assets are in stocks,” says Bajaj. “Most people usually ignore investments like EPF, PPF, etc while calculating their
asset allocation. If they consider all of them, their status can change from ‘aggressive’ to ‘moderate’,” says Melvin
Joseph, Founder, Finvin Financial Planners.

Everyone needs debt products: Though debt offers low returns, investors can’t ignore it altogether. This is because
every investor’s first financial goal should be to create contingency corpus—a liquid corpus that can take care of 3-6
months’ expenses. A large portion of this needs to be in extremely liquid instruments such as bank FDs that can be
broken immediately (you may need funds immediately in case of medical emergency, even if you have medical
cover) and the remaining can be with liquid funds. Since these are debt products, the remaining portion only can be
allocated to other asset classes.

Your age: Age is a major influencer in deciding asset allocation. The ‘100 minus your age’ is the most commonly
used thumb rule for equity allocation. It says that young investors should have higher equity allocation (eg investors
with 25 and 35 years of age should have equity allocation of 75% and 65% respectively), while older people should
have lower equity allocation. Young investors have smaller portfolios (Rs 1-2 lakh) so the absolute loss will not be
as painful compared to a bigger portfolio (`40-50 lakh) of an older investor. Second, younger people have a longer
investing horizon and can wait it out if the portfolio takes a tumble. Third, they usually don’t have high
commitments like supporting a family, children’s education, etc and can afford to take higher risks.

Willingness to take risk: Many youngsters are not ready to take higher risks. “The equity allocation is right when
investors can take a 20-30% cut in a year without affecting their lifestyle or losing sleep,” says Bajaj. This
willingness to take risk is the investor’s ‘risk appetite’. But this risk appetite is a double edged sword—some people
believe they can take higher risk without understanding the implications. These aggressive investors get jumpy when
their SIPs start generating losses. “Besides the risk appetite, we also have to consider the experience of equity
investing when suggesting the asset allocation of an individual. For example, 50% equity allocation is fine for a 70-
year-old veteran equity investor. But a first-time investor should not have more than 30% in stocks,” says Joseph.

Ability to take risk: Investors also need to consider their ability to take risk. People with steady income streams can
take higher risk with their investments because the market volatility won’t affect their lifestyle. This should be a
critical consideration while allocating retirement corpus because the ability to take risk can vary with age. “Several
investors get nervous close to retirement. Risk appetite or risk taking ability can also change due to health related
issues. So qualitative factors like this also should be considered while fixing asset allocations,” says Joseph.

Time period to goal: The time available for the goal is equally critical. The general rule is that invest more in
equities if the time horizon is long and in debt if it is short. Stock market volatility comes down as the investment
horizon increases. As a thumb rule, don’t put any money into equity if the holding period is less than three years.
Increase the equity component if the holding period is more. Some experts say that if the goal is 10 years away, you
should invest the entire corpus in equities.

Goal level or individual level: Asset allocation should be primarily based on the time available for the goal. If the
equity exposure is high, it should then take into account other parameters such as the investor’s age, risk appetite,
risk taking ability. Suppose all the goals of a young investor are long term (8, 12 and 15 years). Even then, the entire
allocation should not be to equities. “The investment portfolio, regardless of the time frame, should be balanced.
Never put the entire money into equity just because all the goals are far off,” says Agarwal.

This may contradict the general principle that equities generate the best returns in the long term. But this
modification is needed to give investors peace of mind. “The purpose of balanced portfolio construction is not to get
the highest returns, but to reach the goal comfortably,” says Joseph.