One of the most common advice given to investors is,' Do no put all your eggs in your basket'. This essentially means that investments should be spread across different asset classes. This suggestion also brings forward the concept of portfolio diversification which propagates allocation of investible amount into different asset classes based on certain parameters. However, the problem with investors is that they ignore the most critical ingredient of diversification which is known as correlation. They invest with the belief that investment in different assets automatically results into diversification. On the face of it the portfolio looks diversified, but pratically lacks benefits of diversification. In order to make diversification work, the correlation between different asset classes should be clearly understood.
In order to understand benefits of correlation, let us first look at the concept of correlation. Correlation shows relationship between movements of different asset class. In simple words, when one asset class ,say shares, give positive return while another asset class gold gives negative return, it can be concluded that the correlation between shares and gold is negative. It is important for investors to understand correlation factor before allocating investments across asset classes. Let us look at some examples where correlation can give benefits of investments:
Equity and debt often show opposite return behavior: It has been often seen that when rate of interest goes up, the value of equity shares goes down, while the return from debt instruments goes up. So in a rising rate of interest scenario, it will in interest of investors to have more of debt in the portfolio and reduce equity exposure. As rate of interest goes down, the reverse can be done. This decision primarily is driven by the fact that rate of interest or return from debt and equity are generally inversely related. Diversification works well in this kind of scenario. Also high rated debt instruments are almost risk free. This helps in diversification of portfolio by keeping portfolio relatively risk free.
Two schemes of mutual funds do not essentially result into diversification: Investors often invest with the assumption that investments in different schemes of mutual funds will result into more diversification. However, reality is different from this. As an investor, you need to check whether different schemes of mutual funds selected by you are investing in different kind of stocks. If you end up selecting two schemes in which there are commonalities in terms of investments, diversification benefits will be limited. So ensure that mutual fund schemes selected by you are well diversified themselves.
Combining high beta stocks with defensive stocks: In rising market, high beta stocks give you high return while in falling markets these stocks become drain on your investments. In order to avoid the downside risk and avail benefits of diversification, it will make sense to combine these high beta stocks with defensive stocks such as FMCG and Pharma stocks. The experience of last five years shows that while stock market has not given good returns in general, pharma and FMCG stocks have been consistent performers. Diversification of equity portfolio will work for an investor if this kind of investment strategy is adopted.
Gold as an asset class adds to diversification benefits: It is often said that gold continues to perform when all asset classes fail to do so. Investors often switch to gold as an asset class during periods of crisis. It makes sense to hold gold in your portfolio to minimize portfolio risk. Gold has a negative correlation with many of the asset classes such as equity and debt. For investors holding commodity such as crude in their portfolio, gold works as an asset which gives diversification benefits.
It is extremely important to note that diversification does not mean more assets in portfolio, it means having assets whose correlation is well defined. Benefits of diversification is maximized when portfolio is created on correlation benefits.
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