Diversification Strategies For Indian Investors

Broadly, equity operates at a high risk with a growth or wealth accumulation as a goal which could yield on average of 12-15 per cent in the long run. Then there’s fixed income (FDs, bonds, G-sec, etc.) which provide stability to the wealth with limited or low volatility yielding about 6-8 per cent returns on average

In previous article, we discussed how risk in equity investing goes beyond volatility and depends on the severity of potential outcomes. One of the most effective ways to manage risk is diversification - spreading investments across different assets to reduce reliance on any single one. But how should Indian investors approach diversification? What strategies work best in India’s unique market conditions? And does diversification always lead to better returns, or can it backfire? Let’s explore further about the various diversification strategies for investors.

Markets, particularly in India are known for high volatility due to political changes, policy decisions, global situations (like war, pandemic, etc.) and liquidity swings (currency fluctuations, crude prices, etc.), sectoral rotation (this has increased and shortened post-covid) and possibly concentration risk where a few stocks dominate the entire market. This was particularly evident during the 2018-’19 period when just top five stocks in the index (NIFTY) comprised about 60 per cent of the entire index.

Such scenarios only highlight the need for diversification in the investors’ portfolios. Without that they could huge losses due to macro shocks (like demonetization, etc.), sectoral crashes (like real estate in ’20) and single stock collapses (like that of yes bank, etc.). While the idea of diversification is to hold unrelated asset classes or sub-classes, practically there could be many indirect orders of impact that could influence the dependency. First is to distinguish and understand the role and use of various assets.

Broadly, equity operates at a high risk with a growth or wealth accumulation as a goal which could yield on average of 12-15 per cent in the long run. Then there’s fixed income (FDs, bonds, G-sec, etc.) which provide stability to the wealth with limited or low volatility yielding about 6-8 per cent returns on average. Of course, Gold (in physical or financial form) could be used for hedging against inflation with a medium volatility (relative) generating about 8-10 per cent returns. Real estate (REITs, physical, etc.) could play as an inflation hedge and wealth creation roles with about 7-9 per cent returns over longer horizon.

Data over the last two decades suggest that a 10 per cent exposure to gold has not only potentially reduced volatility but generated better risk adjusted returns. In a 60 per cent equity, 30 per cent debt and 10 per cent gold has generated about 11 per cent annualized return with much lower volatility compared to a pure equity (100 per cent to NIFTY) investment. This is evident with 35 per cent drop in this portfolio compared to about 55 per cent in pure equity during the GFC of ’08. Similarly, during the Covid crash, the pure equity fell by 38 per cent compared to just 18 per cent in a 60-30-10 portfolio. By the end of the year, Dec ’20, this portfolio fully recovered with +16 per cent returns while the pure equity was struggling (-11 per cent) to get past the pre-Covid highs.

Coming to the intra asset diversification i.e., sub-class, it could be done through sectoral allocations or market cap basis. And there’re lot many factors (like quality, value, momentum, etc.) to segregate and deploy according to the needs. It also depends upon being contrarian or in-line with the index i.e., if the sectoral allocation is done keeping in mind, the index composition then banking and financial services could occupy a third of the portfolio. But, for instance, in 2019, even 10 per cent allocation to pharma which comprised a low single-digit in the index, could have benefited for the investors in two years as the index weightage jumped up by 50 per cent.

Creating a portfolio with a multi-cap stock exposure also allows to generate better returns with a lower concentration risk. The free-float of the category wise capitalization is 70 per cent to large caps (over 50KCr), 20 per cent to mid-caps (over 15K < 50K) and about 10 per cent in small caps (<15K) generating resp 14.1 per cent, 18.3 per cent and 21.7 per cent returns annually over the last 10 years with a maximum drawdown of -38 per cent, -45 per cent and -60 per cent. The drawdown is during 2018 for small caps while it’s the covid lows for the rest. While small caps outperformed large caps, they also experienced two times more volatility. Relatively midcaps generated better risk adjusted returns during this period.

So, within equities, a conservative approach would be to reflect the total capitalization proportion of the market, thus, 70-20-10 to large, mid and small cap. A moderate risk approach would change that to 50-30-20 while an aggressive approach involves 30-40-30 mix to the portfolio.

Geographical diversification is another way to generate higher returns. The past 10-year data of US equities, however, shouldn’t blind us to the risks into the future. Despite, investors could explore 10-15 per cent of the portfolio to global allocation would benefit in the long term.

Reiterating, diversification isn’t about avoiding risk but surviving through the tough periods to grow another day.

The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected]