“Making the simple complicated is commonplace; making the complicated simple, awesomely simple, that’s creativity.” – Charles Mingus
During the decades of self observation and interactions with various fellow investors, one thing i begin to realize is that the first solution that pops up in our mind is usually not the best or simplest. Time after time, people will preach the benefits of diversification so loudly over radio, podcasts, TV channels, newspaper etc. that every person start believing that the diversification is the key to success in the field of investing. I for the one can not deny its benefits on the contrary i have been advocating the same, Though most of the messages around diversification are not received correctly.
Lets try to understand and go through some common advises on diversification we receive, I am sure you would have heard at least couple of them if not all.
- Don’t put all your eggs in one basket
- Diversify across various investment options for better risk & returns
- Diversify across AMCs to avoid any concentration risk with an AMC
- Diversify across various capitalization (size of companies) for better returns
- Do not have overlap of holdings in fund
- Diversify across investing style like growth vs value investing
- Diversify across various geographical locations
- …And the list continues
Hope you got the gist that the list is never ending. Important point is to understand that a novice investor take these advises coming from opinion leaders and follow it literally (Yes literally!). Let me share a true example portfolio of a person investing for >3-4 years and have aggressive risk profile so discarded all other asset classes to focus only on equities. He held funds mostly from different AMCs; 2 Multi-caps, 2 Large caps, 2 mid caps, 4 ELSS, 1 small cap and 1 value fund. In total, he had 12 funds and on inquiring about his logic, he referred to the point 3-5 from the above list. All were active funds and in total he owned 405 individual stocks through these active funds. He is not the only person, in another example a friend had 1 large-cap, 1 Multi-cap, 1 Debt fund, 1 Intl FoF, 1 Focused equity fund and 3 sector funds. In total, across 8 eq funds he owned 385 individual stocks + an intl fund.
If you have started your investing journey, your own portfolio might be looking like same or might have looked the same or probably one person you know might have the portfolio with same attributes. Such portfolios are pretty pleasing most times as they will have a winner that is generating handsome returns. Even when others are generating mediocre or lower returns, you would always be pleased with your investing acumen because of that winner in your portfolio. Though such portfolios are poorly constructed, because most of the funds would have a correlation of >0.5 to 0.7 among them and too costly to hold.
Let me elaborate why? when the market fall at the start of this year, both of the portfolios I mentioned earlier had fallen by almost same proportion as the overall market. This basically means that portfolio diversification failed to do one thing that it was meant to do, reduce the risk in portfolio. So if the above strategy has failed, how should we diversify to get the benefits.
first, The step 1 of diversification is the mix of various asset classes. In most cases, the different asset classes behave differently. When the equity returns fall in Feb/Mar 2020, all the central banks pivoted to increase liquidity and reduce rates. As a result, the returns of long duration gilt funds have been fantastic and the gold has been safe heaven. Therefore, as a investor the step one for us should be split our investments into various asset classes like Equity, Debt, Gold, REITs, Real estate etc.
Second, Decide on the constituent of the asset classes. This in itself could be book in itself but let me try to share the summarized version of best practices across the asset classes from investing perspective.
- Direct Equity: If you are a stock investor and most of your equity holdings are in form of stocks and shares, you need to make sure that your holdings are from the various market sectors and in total you have no more than 20-25 stocks and no less than 10 stocks. Though new investors are not advised to invest in stocks directly or if your portfolio size is less than INR 1 mm.
- Equity Mutual Funds: Mutual funds are wonderful instrument for equity investing. Specially when you do not have the expertise or time to follow, track & select the individual stocks. You can leave the process to experts and still own a diversified equity portfolio with as low as INR 5,000/-. You can belong to the camp, which believes that fund managers can actively select the stocks to outperform the broad stock market or the markets are efficient and investing in passive funds is superior. If you are the believer in the active fund Mgmt camp, all you need is two Multi-cap mutual funds or two Aggressive hybrid for your Core portfolio [I personally have only 1 active fund. You can check the details on this link.]. If you belong to passive management camp, again two index funds are more than enough for the management Nifty twins (Nifty 50 & Nifty Next 50).
- Debt Portfolio: In India, you have lot of instruments like Post Office schemes, PPF, EPF, NPS etc so most of the debt portfolio can be funded using those options unless you are in a higher tax bracket in which case Debt Mutual funds should be used. In case of Debt Mutual funds Two funds are more than enough Money Market/ Liquid fund and Medium Duration bond fund. [Why Medium Duration bonds?]
** I covered this in more detail in How to build your debt portfolio series, check those articles.**
- Gold: This is a cyclical asset class and due to the same lot of people are either completely against gold as investment options or completely pro to have 20-25% of asset allocation in gold. I am somewhere in middle, I do suggest to have gold as part of portfolio unless you have a large pile of Gold in form of jewelry holding in family. Three ways to hold gold as investment as per me; 1 SGBs 2 Gold ETFs & 3 Gold Mutual Funds.
**Do check the details if you are yet to invest in gold, Have you missed out on the rally in gold?**
- Real Estate or REITs: Real estate in itself was the asset of generation. Specially when you have a large portfolio of multiple crores, the volatility in equity can be a reason for headache. The rental income via residential or commercial property can be a good source of regular cash flow. Though as a small investor you can look into REITs, these can be a good source of regular income but market is still developing for the same in India. Keep an eye of it. One thumb rule to follow is that we should keep our exposure to the real estate <40% including the real estate for self use.
Lastly understand this about the Indian stock market; Top 100 companies on Nifty makes 75%+ of Market free float, Next 150 companies would make another 12-15% and it is incrementally decreasing. Why it is important to understand this? Because if you believe in active management advantage, you can not spot 200+ stocks which are profitable, growing, better RoE etc to invest in. Therefore holding 200+ stocks via various active mutual funds are going to be a recipe of disaster because returns might not come but cost will stay with you.
In summary, a good diversified portfolio could be constructed with a handful of mutual funds itself. You need to focus on the asset class diversification vs increasing the number of equity funds alone for better risk management. Happy Investing!
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