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Photo: iStock
Photo: iStock

Opinion | Manage risk in your portfolio or it will erode its value over the long term

The higher the risk, the slower will be the compounding of returns over the long term

Everything I knew and understood about risk and diversification changed in the last six months. Months of the rigorous tests and analyses my team and I did combined with discussions with leading academics and practitioners proved that managing the risk of your portfolio can significantly increase your portfolio’s value over time. Here’s the simple mathematics of it—a portfolio with reduced risk leads to smaller swings in portfolio value, which in turn leads to faster compounding of returns, making your portfolio value higher than that of a higher-risk portfolio.

Managing risk is more relevant today than it has ever been. Indian equity markets have experienced a 25% or more drop 10 times since 1991, an average of once every three years, as a result of the increasing frequency of massive market corrections like the one due to covid-19. Why should you face portfolio-value drops of 30-50% every three to four years? These steep drops mean that your portfolio will take much longer to recover to peak value. Why should your portfolio returns compound at lower rates just because Indian equities swing wildly? What if your portfolio was diversified to include assets that were less risky or that performed well when Indian equities fared poorly?

Risk is measured by a statistic called standard deviation. In the world of investments, it refers to the range of the asset’s returns two-thirds of the time. For example, for the 15 years ended December 2019, the standard deviation of the Nifty 50 Index was 32%, while its average annual return was 19%. This statistic implies Nifty 50 Index’s returns ranged between -13% (19% - 32%) to 51% (19% + 32%), in 10 of the 15 years. Likewise, the standard deviation of the Nifty Smallcap 250 Index for the same period was 51% and its average return was 25%, implying its returns ranged between -26% to 76%, in 10 of the 15 years. Essentially, standard deviation tells you precisely how much your portfolio could swing over time. The higher standard deviation for the Nifty Smallcap 250 Index (representing small-cap stocks) means it is riskier than the Nifty 50 Index (representing large-cap stocks).

While some of us understand this basic explanation of risk, three core implications of risk are less understood. First, higher the risk, higher the number of negative-return years for a given asset. For example, the Nifty 50 Index had negative returns during three years in the 15-year period, while the higher-risk Nifty Smallcap Index has four years of negative returns.

Second, higher the risk, higher the drops in portfolio value during bear markets. For example, the two worst falls for the Nifty 50 Index in this period were -51% and -24%, while the two worst falls of the higher-risk Nifty Smallcap Index were even greater at -69% and -35%.

Third and the biggest implication of risk for us is that higher the risk, slower the compounding of returns over time, leading to lower portfolio value at the end. The Nifty 50 Index’s 15-year average annual return of 18.9% reduced significantly to a 13.9% compounded return over 15 years due to the meaningful risk of Nifty 50 Index (standard deviation of 32%). The even higher 25% average annual return of the Nifty Smallcap 250 Index crumbled down to 13% compounded return due to its even higher risk (standard deviation of 51%) than that of the Nifty 50 Index. In stark contrast, the US’s S&P 500 Index’s 15-year average rupee return of 13.8% reduced only marginally to a 12.7% compounded return over 15 years because its standard deviation was only 16%. So, we can see how a higher standard deviation or risk implies your portfolio has to work that much harder to grow over time.

While picking lower-risk assets is one way to reduce portfolio risk, the more powerful way is diversification as it reduces risk. It is more than “having your eggs in more than one basket". Diversification is about mathematically minimizing the risk of your portfolio by adding assets whose prices behave differently in response to market events. For example, the S&P 500 Index is not only less risky than the Nifty 50 Index but also its price behaves quite differently. In most cases when the Nifty 50 Index is down by more than 15%, the S&P 500 Index is actually up. Therefore, adding the S&P 500 Index to a Nifty 50 Index portfolio could actually increase portfolio returns over time.

To summarize, you can reduce the risk of your portfolio by adding asset classes that are low-risk and, more importantly, whose prices behave differently. With such a portfolio, your portfolio value is bound to fall less in tough markets and, therefore, grow faster over time.

Apurva Patel is founder of Synergy Capital Partners, a Sebi-registered investment adviser and Sebi-registered PE fund manager

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