Why diversification is still the best game for India’s retail investors

It’s now expected that RBI will start cutting rates, leading to bond yields falling  and bond prices going up
It’s now expected that RBI will start cutting rates, leading to bond yields falling and bond prices going up

Summary

  • It ensures that retail investors will be in a position to benefit from any asset class doing well or limit any losses

Retail investors are going through a very good phase. Stock prices have reached never before seen levels. Interest rates on bank fixed deposits and small savings schemes are higher than inflation. Gold prices have also gone up over the last year. So, how should a retail investor play this? Before answering that question it is important to understand why we are where we are.

What about stocks?

In its latest monetary policy meeting on 12-13 December, the US Federal Reserve said that it expects the federal funds rate to be at 4.6% by end 2024 and lower thereafter, down from the earlier forecast of 5.1%. The federal funds rate is the rate at which banks in the US lend money to each other on an overnight basis. The rate currently stands at 5.25-5.5%. If the Fed cuts this rate 25 basis points at a time, it will have cut the rate thrice for it to be at the projected level. One basis point is one hundredth of a percentage.

Now, how does all this impact the Indian retail investor? With the funds rate being projected lower, the Fed is trying to tell the world that it expects the interest rates in the US to come down. Lower US rates mean that large institutional investors will earn lower returns on their US fixed income investments.

So, they’ll look for higher returns across the world. In fact, foreign institutional investors (FIIs) have already been doing that, given that they were banking on the Fed cutting interest rates in 2024. From 1 December to 15 December, they have net invested 42,733 crore, or $5.13 billion, in buying Indian stocks. And this is why the BSE Sensex, India’s most famous stock market index, has risen 6.7% since the end of November and up to 15 December.

The FIIs had sold stocks worth 39,316 crore during September and October, a period during which domestic institutional investors (DIIs) net bought stocks worth 48,567 crore. DIIs are firms like mutual funds, insurance companies, pension and provident funds, banks, etc. Much of the money they invest is handed to them by retail investors.

Now, it’s only because of massive FII buying, along with some buying by the DIIs, that stock prices have rallied. In December, the DIIs have net bought stocks worth 3,182 crore, after having net bought stocks worth 14,254 crore in November, when FIIs had net bought stocks worth 9,001 crore. These details explain the recent uptick in stock prices. Of course, over and above this, retail money has been gushing into small-cap stocks driving up their prices.

What about bonds?

With interest rates in the US expected to fall, bond yields are falling. The yield on a bond at any point of time is the per year return that investors can expect if they invest in the bond and hold on to it until maturity. As can be seen from Chart 1, the yield on the 10-year US treasury bond had been rising through the year, but it’s now falling, given the expectation of lower rates. Treasury bonds are financial securities issued by the US government.

Now, yields and prices are inversely correlated. With bond yields falling, bond prices in the US have been going up. This means higher returns for investors who had already invested in bonds or mutual funds which invest in bonds. Again, how does all this impact the Indian retail investor?

The Fed sets the direction of the global monetary policy. So, it’s now expected that the Reserve Bank of India (RBI) will also start cutting rates and that will lead to bond yields falling and bond prices going up. Which is why some experts have now started recommending gilt funds or funds which invest in government securities, to cash in on bond prices going up.

The yield on the 10-year government of India bond was at 7.28% as of 30 November and fell to 7.16% as of 15 December, a fall of 12 basis points. In comparison, the yield on the 10-year US treasury bond fell by 46 basis points to 3.91% during the period.

So, the Indian bond market is not yet convinced about the RBI monetary policy following the Fed, at least not straight away, given that inflation—at 5.55% in November—is still on the higher side.

 

(Graphic: Mint)
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(Graphic: Mint)

What about gold?

On the expectation of a weaker dollar, gold prices have been mostly higher than $2,000 per ounce (one troy ounce equals 31.1 grams) over the last few weeks. With interest rates in the US likely to fall further, dollars will leave the US while chasing returns in other parts of the world. Investors following this strategy need to sell dollars and buy the currency of the country they want to invest in, leading to a surfeit of dollars in the system and hence, a fall in its value. Since the dollar and gold are inversely correlated, the chances of a weaker dollar are leading to a stronger gold value. Before this logic started to be offered, gold was rallying because of high inflation through the Western world.

In dollar terms, gold has given a return of around 14% in the last one year. Returns in rupee terms have been around 16%. Nonetheless, returns in dollar terms have been flat since August 2020, when gold prices had briefly crossed $2,000. In rupee terms, the return has been around 16%. In that sense, which way gold will go remains very difficult to predict.

Diversification strategy

One thing that clearly comes out of the above analysis is that the reasons driving different markets are very macro in nature. And given that it is very difficult for a retail investor to keep track and act accordingly.

Also, strong incentives are at work. If you ask those in the business of selling stocks, they are likely to tell you that stocks remain the best investment. The same logic works with bonds and gold.

So, diversification or not putting all eggs in one basket, like always, still remains the best way to invest, ensuring that the investor will be in a position to benefit from any asset class doing well. Also, if things don’t go the way they should have, then the losses or a lack of a return from that asset class are likely to remain limited.

Of course, if one particular asset class does well and investors’ allocation to it is limited, given that they are following the diversification strategy, then their returns will be limited in comparison to a concentrated investment strategy that bets big on one particular asset class. That’s the cost of diversification. On the flip side, if the value of an asset falls, a concentrated investment strategy can lead to losses as well.

And it is worth remembering a little bit of history about small-cap stocks. The BSE SmallCap Index had stood at 7,004 points as on 2 January 2007. It doubled to 13,975 points by 7 January 2008 and then fell by almost four-fifths to 2,867 points by 9 March 2009. Also, the high of 13,975 points reached in January 2008 was crossed again only on 16 March 2017, more than nine years later.

Vivek Kaul is the author of Bad Money.

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