Diversification is the key to managing wealth. But, where should you begin?

Why should you diversify?

Reduces risk: Diversifying investments helps to reduce the risk of losses from any single investment or a single AMC (asset management company). For example, if an investor has a portfolio of mutual fund schemes across eight categories, then a fall in the mid-cap stocks segment will have a smaller impact on their overall portfolio, compared to someone who invests solely in the mid-cap space.

Provides stability in returns: Diversifying investments also helps to stabilize returns by spreading investments across different assets that have low correlation and may perform differently in different market conditions. This way, an investor can benefit from the potential growth of different types of assets and minimize the impact of any single investment’s underperformance. For example, equity and debt have low correlation.

It’s important to have actual and not an optical diversification. Optical diversification is when you have many products which behave similarly in your portfolio. Actual diversification can be achieved by taking exposure to products that behave differently in different market scenarios, or belong to different sectors or different asset management companies (AMCs). Say, you have 10 funds in your portfolio, all from a single AMC. This would be optical diversification as you have 100% exposure to one AMC and this will increase your AMC risk.

How to diversify

Through different asset classes: There are a vast number of assets for one to pick from and each comes with its set of risk and return trade-off and an investor based on his taste for risk can create his/her basket. An investor will most often choose from one of the asset classes mentioned in the table. We have tried to capture their average risk and return potential. As we can see from the two scenarios, diversification plays a great role in portfolio performance.

Through different product categories: In a particular asset class, you have different products, however you need to understand whether you need all or a few of them. Say, equity has four products—direct equity, portfolio management services (PMS), mutual funds (MFs) and alternative investment funds (AIFs). If you choose all products from the same asset class, your portfolio will fail to diversify. Say, if you are opting for equity MF, you can avoid PMS as they a behave in similar manner and MF is more cost- and tax efficient.

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Through market cap: There are 15 categories of MFs, out of which six are market cap based. It is wise to opt for categories in a balanced manner which have been consistent in their alpha generation potential and have done well in different market cycles. It is ideal to maintain large-cap, mid-cap and small-cap allocation at 50:30:20 ratio at a portfolio level.

Through style: There are two styles of investing, growth and value style. A fund manager following value style would invest in fundamentally strong companies that are trading at valuation levels below the market level. A fund manager following growth style would invest in fundamentally strong companies that have high earnings growth potential compared to peers. Value style tends to do well in a bull phase and growth style tends to outperform in the bear phase. A blend style would indicate that the fund managers are agile and keep shifting between styles depending on market scenarios.

Diversification is extremely important to reduce risk and enhance the stability in the portfolio. Of all the methods of diversifications, asset allocation is pivotal. This is the most important component while setting goals and reviewing one’s portfolio.

Feroze Azeez is deputy CEO, Anand Rathi Wealth