Not easy to diversify investment

It is not uncommon to hear suggestions such as ‘diversify’ your portfolio and think ‘long term’ when the market is full of uncertainty. Now, we discuss what it takes to diversify.

Statistically speaking

To diversify your portfolio, you should look at how a new investment you want to make is statistically related to what you already have in your portfolio. Suppose you hold units in a large-cap active fund benchmarked to the NSE 100 Index. Further, suppose you want to invest in a mid-cap active fund. You are expected to look at how the mid-cap fund’s returns correlated to the large-cap fund’s returns in the past. That requires you to gather past returns and statistically test how the funds behaved over time. This is when you diversify within an asset class. When you diversify across asset classes, you ought to do the same exercise between, say, equity and bond returns. Is that something we can continually do as individual investors? And that is not even the major issue.

Empirical evidence suggests that correlations are unstable over time and across market conditions. That is, two asset classes may have a weak correlation with each other when the market is moving up, but have a strong correlation when the market crashes. You ought to consider these changing relationships to build a meaningfully diversified portfolio. So, the next time you are told to diversify your portfolio, you should ask the person giving the suggestion on how to do it. Often, the term ‘diversification’ is thrown into a conversation that involves managing risk. The point is you must do a lot of analysis if you want to manage risk by applying the conceptually accurate diversification process.

Conclusion

Often, when someone mentions diversification, they often mean spreading savings across multiple investments. But diversification is more about the statistical relationship between investments, not the number of investments you hold. What is the point of holding 10 different mutual funds if all the funds invest in a similar set of securities? It is best to ask questions when you are given such suggestions. Being told to ‘diversify’ investments and suggesting that you hold investments for the ‘long term’ is not useful unless you are given a workable process to implement such suggestions to achieve life goals within a desired time horizon. There is indeed a lot of difference between talking about an investment concept and applying it in practice.

(The author offers training programmes for individuals to manage their personal investments)