Every experienced investor carries the memory of at least one market downturn that tested their conviction and challenged their strategy. Markets in India have experienced several sharp corrections over the past two decades – each driven by different triggers, each creating panic among participants who were not positioned for the associated volatility. The investors who navigated these periods with the least permanent damage to their wealth were, almost universally, those who had built genuinely diversified portfolios before the stress arrived. Diversification is not just a theoretical concept discussed in investment textbooks – it is the practical framework that any investor can implement through the securities held in their Demat Account and managed through whichever trading apps they prefer.
What True Diversification Actually Means
Many investors think that they have achieved diversification by merely owning more than one stock. Thus, having ten information technology stocks does not represent a diversified investment. Diversification is about having a portfolio comprising different kinds of assets, where each asset has a different engine that drives its price and, therefore, diversifies the risks.
In the case of equities, diversification is achieved by having exposure to different sectors such as financial services, healthcare, consumer goods, technology, industrials, and energy, as well as different market caps such as large-cap, mid-cap, and small-cap. Apart from different kinds of equities, a diversified portfolio has exposure to debt, gold, and real estate, among others. All these assets have varying relationships with the economy, and, therefore, a combination of these assets is more diversified and less risky than individual assets.
Sector Diversification and Why Concentration Is a Hidden Risk
One of the biggest diversification pitfalls for Indian investors is the inadvertent concentration in a sector. An investor who has exposure to private sector banks, housing finance companies, insurance companies, and asset management companies may think that they have a well-diversified portfolio. However, in reality, the investor has concentrated their money in the financial sector. Thus, any news related to the financial sector would affect the portfolio value of the investor. The same applies to investors who have exposure to multiple information technology companies. Regardless of the company size, the entire portfolio is exposed to one sector, which is the information technology sector.
The simplest way to check whether there is a hidden concentration is to make a sector-wise list of all the stocks in the portfolio. The list would show the percentage of the portfolio value exposed to each sector. A similar approach can be applied to other asset classes such as debt, gold, and real estate.
The Role of Debt in an Equity-Dominated Portfolio
The conventional belief is that investors should hold more equities when they are young and start reducing the exposure to equities and increasing the exposure to debt when they grow older. However, with the consistent fall in the rates of interest on financial instruments such as fixed deposits, many investors have found it unappealing to hold on to debt instruments. As a result, many investors have chosen to hold more equities as compared to fixed deposits in their investment portfolio. However, what many investors fail to realise is that debt funds have a special place in the portfolio of a typical investor.
Debt instruments play a crucial role in a portfolio that has a higher exposure to equities for a variety of reasons. First, unlike equity, debt funds provide capital protection, which is particularly crucial in volatile markets. Second, debt instruments can serve as a liquidity provider to an equity-dominated portfolio. In other words, by having exposure to debt, an investor can utilise the liquidity provided by the debt instruments to buy equity funds when the latter is available at discounted prices. Third, investors with a specific financial goal such as buying a house or a car or paying for their children’s education should consider systematically moving their portfolio from equity to debt as the goal nears. This systematic transfer helps an investor to reduce the risks that come with trying to guess the most appropriate time to exit equity.
Rebalancing: The Mechanical Discipline That Enforces Buy Low, Sell High
Portfolio rebalancing encourages an investor to buy low and sell high. By periodically rebalancing the portfolio, an investor can benefit from selling those assets that have gone up and buying those assets that have gone down. For instance, if the value of equities increases to seventy-five per cent of the total portfolio, the investor would benefit from selling some of the equity shares and utilising the proceeds to buy other assets. This approach to investing is counterintuitive, as most investors would choose to buy more of an asset that has gone up in value rather than sell it. On the other hand, rebalancing would encourage the investor to sell some of the winning assets and buy more of the losing assets.
Apart from helping an investor to adhere to the buy low, sell high philosophy, rebalancing would also help an investor to reduce the risks that come with having exposure to only one asset. In addition, rebalancing gives the investor control over the portfolio. Thus, rebalancing should be part of every investor’s investment process.
The frequency of rebalancing is a matter of personal choice. Some investors may choose to rebalance their portfolio on a yearly basis, while others may rebalance their portfolio every time there is a change of more than five per cent in the values of any of the assets in their portfolio. However, it is important for an investor to consider the tax implications of rebalancing. In the case of an investor who is investing in taxable accounts, it may be more advantageous to rebalance through fresh investments rather than by selling existing assets, as the latter could incur taxes. Thus, for such an investor, it may be useful to utilise rebalancing to invest more money in assets that are underweight in the portfolio rather than selling some assets in overweight segments of the portfolio and rebalancing the portfolio.
