Investment Diversification: A Strategy To Earn High Returns at Low Risks [2020]

What is investment diversification? Which is the best strategy we can use to diversify our investment portfolio and minimise risk...

Diversification: Including different types of non-related assets in portfolio is called investment diversification.

It is a strategy to minimise the risk of loss in case of unpleasant price movements.

Example: Suppose you bought stocks in the past for Rs.50,000. As on today, the price of this stock is down 5%. In the same period, you also bought gold ETF of Rs.50,000. The price of ETF is up by 8.5% as on today. The net effect is that, your portfolio is up by 3.5%.

Even if the stock price was down by 5%, but this loss was compensated by 8.5% gains by Gold ETF.

This is an example of a diversified portfolio which has two unrelated assets (stocks and gold).

When to Diversify Investment?

In the above example, uncle Sam might say, …”had you invested only in gold ETF, your gain would have been 8.5% instead of 3.5%…“.

Uncle is not wrong, but at the point of investing, you did not knew that stock will perform badly. So, what is the lesson?

When we are “not sure of the future performance of our assets”, better is to spread the money into different non-related assets. This strategy must be used by investors while they are making unsure investments.

What are unsure investments? Those investments where sufficient “self research” has not been done by the investor.

There can be two main reason why people do not research before buying investments: (a) due to lack of know-how and/or (b) lack of time.

If you are falling in these two categories, it is a hint that the strategy of investment diversification is necessary for you.

The Strategy: Investment Diversification

Investment portfolio must at least have two non-related assets. If you are an equity investor your strategy should look like this:

Investment Diversification - strategy - Distribution of funds in portfolio

There are few take-aways from the above infographics. The main inference is this – “the investors portfolio should never have 100% equity”. Other more discernible inferences are these:

  1. Equity (Max-Min): The maximum allowable limit of equity exposure is 75%. Having said that, this is also true that an investor should also not reduce his/her equity exposure below 25% under any condition. Read: Economy works in cycles.
  2. Overvalued Market: At a time when Sensex & Nifty are touching all time highs, this is the moment when weight of stock should be minimum (i.e. @25% levels). This is not a time to buy. It is a time to sell & book profits. Sell stocks and use this fund to buy ‘other assets’.
  3. Undervalued Market: When Sensex and Nifty is bleeding, this is the time to buy stocks. It is not the time to sell stocks. This is the moment when the stock weight should be maximum (i.e. @75% levels). At this time sell ‘other assets’, and buy good stocks. Read: Why to invest in bear market.
  4. Other Assets: When weight of equity will reduce in portfolio, weight of other assets will increase and vice versa. Its relationship with equity is inversely proportional. Other assets can be like bonds, deposits etc. Read: How to build assets.

What has been said in the four bullet points above is called “portfolio balancing“. Depending on a market condition, weight of equity in the portfolio changes. A subsequent increase or decrease in equity-weight is altering the weight of ‘other assets’ as well.

So what we can conclude from this learning?

Investment diversification is a dynamic activity. As important it is to include different asset class in portfolio, it it equally important to keep the “portfolio balanced” depending on the market conditions.

Market Conditions

Generally speaking, there can be two types of market conditions, overvalued or undervalued. How to judge if the market is over or undervalued? Here are few indicators:

  • Overvalued Market: This is a market condition where good stocks (equity) will be overvalued. Hence buy less stock now. In this condition, pro investors sell equity and buy other better valued assets. For new investors, this is a time to stay way from stocks. Why? Because stock market correction can happen anytime. Keep money as cash or buy assets like bonds, deposits etc in such times.
Investment Diversification - Market Conditions - Overvalued
  • Undervalued Market: This is a market condition where good stocks trade at undervalued price levels (example year 2008-09). This is the best time to buy blue chip stocks. In this conditions, pro investors buy maximum stocks. For new investors, this is a time to enter the stock market. Arrange as much money as possible (liquidate other assets) and use them to buy good stocks.
Investment Diversification - Market Conditions - Undervalued

Transition Phase

But what we have spoken is about the two extremes. Here the market is either at the peak or at the bottom. But market generally do not remain at these boundary conditions.

They often trade somewhere in between. We can call this as a transition phase of the market. Most of the time, our market remains in this phase.

What should be our investment diversification strategy in transient market times? These are times where often it is tough to judge where the index is heading (down or up).

This is the phase where investment diversification is most required. In such times, our portfolio should look something like this:

Investment Diversification - Market Conditions - Transition

In a transition phase, for a lay investor it is most difficult to judge whether a stock is overvalued or undervalued (Read: How to invest in share market).

Hence at this point to time, maximum care must be taken while investing in equity. How to do it? By investing in following types of mutual funds.

  1. Index Funds: Here index funds should not track any sector specific indices. It must track broader indices like Nifty, Sensex, BSE100, BSE LargeCap etc. The benefit of such index funds is that, their portfolio is very well diversified. How? Because they contain stocks of wide variety of companies and sectors. Read: Index vs active funds.
  2. Multi Cap Funds: These mutual funds include all type of stocks in its portfolio. Their criteria is to include any stock from an umbrella of large cap, mid cap and small cap, which are undervalued. This is perhaps the best type of mutual funds for a lay investor for all times. Read: Types of Mutual Funds.
  3. ETFs: Exchange Traded Funds (ETF’s) are basically index funds whose stocks are listed in stock market. Yes, we can buy units of ETF’s like we buy stocks using online trading platforms. If you are somebody who like stocks, in transient market times, you can buy/sell index ETF’s. Read: About Exchange Traded Funds (ETF’s).

Asset Types for Investment Diversification

Here we will discuss few asset types over which we can spread our money upon investing. I’ll try to explain this with two hypothetical examples. First example will depict an overvalued market scenario, and second will depict undervalued market.

Example #1: Overvalued Market

  • Sensex: Today is 12th-Dec’19. Sensex is trading at 40,600 levels. On 28th-Nov’19 Sensex touched it all time high of 41,100 levels. This is a strong hint of overvaluation.
Investment Diversification - Example1 - Sensex
  • GDP Growth rate: In last 8 months, GDP growth rate has been continuously declining. In Jun’19 it was close to 8% market. But in Nov’19 its down to 4.5%. When GDP growth rates are falling, Sensex generally gets weaker. But the market is till bullish. It is a sign of overvaluation.
Investment Diversification - Example1 - GDP
  • Interest Rate: Since Feb’19 till Aug’19, 10Year government bond yield fell from 7.68% to 6.33%. But since Aug’19 interest rate is showing a rising trend. When interest rates are rising, Sensex generally starts to taper down. But market is still bullish. It is another sign of overvaluation.
Investment Diversification - Example1 - Interest

These are clear signs of market overvaluation.

How an new investor should build a well diversified portfolio in such market conditions?

Suppose you have Rs.1,00,000 available for investing. How you must spread this money to have a well diversified portfolio? As the market looks overvalued (at its peak), distribution between equity and other assets should like this:

Investment Diversification - Example1 - Diversified portfolio

Asset: Equity (25%)

Direct Stocks: As the market is overvalued, buying large cap stocks will be a mistake. This is the time where opportunity may be available in mid cap and small cap stocks only. If one knows how to analyze stocks, then go ahead and buy few quality mid/small cap stocks. [Note: In overvalued market, direct stock investing requires extreme care]. But in absence of this know how, better will be to stick to mutual funds.

Equity Mutual Funds: There are equity funds which target only mid cap and small cap stocks. In overvalued market conditions it is better to buy these mutual funds instead of main index funds, or large cap funds. Read: About small and mid cap funds.

Other Assets (75%)

Bonds: In overvalued market buying fixed income instruments like bonds is a good bet. Government or corporate bonds offer reasonable high returns with less risk. Read: How to buy government bonds directly. There are also debt based mutual funds which primarily invest in GOI and corporate bonds. Lay investors can buy such mutual funds.

Bond ETF: Edelweiss AMC is launching India’s first corporate bond ETF in India. This ETF will only buy AAA rated bonds issued by public sector undertakings. This ETF will be a more convenient way of investing in government bonds for a common man. Read: About Bharat bonds.

Fixed Deposits: There can be two types of fixed deposits. One is issued by banks, and another is issued by corporates. Bank deposits are one of the safest investment options. Corporate deposits are also safe but has some inherent risk built-in. Investing in corporate deposits which have credited rating of A+ and above should work. Read: How to value fixed deposits.

Gold: There are two ways of investing in gold, physical or through ETF’s. Both the options are equally good. But before investing in gold, it must be kept in mind that holding time should be more than 10 years. Why? Because in this time band, gold price appreciation is decent. Read: What is e-Gold.

Real Estate: Like physical gold, physical property also provides good diversification for an equity based portfolio. Why? Because equity market and gold/property has negligible correlation. People who cannot invest large sums of money, should try buying smaller apartments in small cities. Read: Property investment guide.

REITs: In our example, the investor has only Rs.100,000 available for investing. With such small amount one cannot buy a physical property. For such investors, there is a option of buying shares of REITs funds. These are like mutual funds, but in their portfolio there are only income generating real estate properties. Read: What is REIT.

Cash: Here by cash I mean money parked in savings account or in liquid mutual funds. Till the investor has not finalised where to invest money, it can lie idle in the bank’s savings account. A better alternative to savings account will be liquid funds. Read: Alternatives to savings a/c.

Example #2: Undervalued Market

Sensex: One of the best visible indicator of undervalued market is Sensex itself. In 2008-09 we saw one of worst stock market collapse of all times. During this time, Sensex plummeted by 56% in just 12 months.

Investment Diversification - Example2 - Undervalued

On Jan’08 Sensex touched its all time high of 20,000 levels. By Jan’09 it touched the bottom of 8,900 levels.

How one should build a diversified portfolio in moments of Jan’09?

Frankly speaking, this is the time where one can care least about diversification. Why? Because from this point onwards, stock market can only go up.

But the golden rule of diversification does not allow one to invest more than 75% in equity. Hence, for a person who has Rs.100,000 for investment, his/her investment portfolio should look like this in times of Jan’09:

Investment Diversification - Example2 - Diversified Portfolio

Asset: Equity (75%)

Blue Chip Stocks: There is no better time to buy blue chip stocks when index has bottomed. Why? Because the price at which these stocks are trading is way below its intrinsic value. But all good stocks trade below their intrinsic value during market crash, why target only blue chips? Because these are the stocks which will first touch back its peak. Moreover, the surety that the price will rebound back is cent per cent for these stocks.

Other Assets (25%)

Keep Cash: In these market times, investor must not care about investing money elsewhere. Focus must be absolutely on picking good stocks at great prices. But 25% funds must be parked elsewhere. Where to do it? Either go for bank deposits or liquid funds. Keep your money handy, you may not know when you’ll need them to buy best stocks.

Final Words

Why one invests money? No matter whatever is the goal, one of the objective of investment is to earn the expected returns.

Market Peak

But consider this, market is at its peak (say Sensex @40,000), and Raj’s portfolio is equity-heavy with heavy weight stocks of Sensex. In this market euphoria, majority like to buy stocks, right? But what happens to such a portfolio when the Sensex corrects itself? The value of portfolio will easily shrink by 10-15%.

Considering that the market was already at its peak, a correction was almost certain. Still people like Raj preferred to stay equity-heavy.

What our investment diversification rules tells us to do in such times? Be lightest in equity (Max 25%). For such people, even if the market crashes, their loss is minimal. Why? Because they are not holding at individual stocks. Moreover, their equity holding is only in index funds etc. See here.

Market Bottom

Similarly when market is at its bottom, what people like Raj do? They are so scared of the stock market that they sell all their holdings at a loss.

What our investment diversification rules tells us to do in such times? Be heaviest in equity (Max 75%). Portfolio is full of blue chip stocks bought at amazing price levels. For such people, the gains will be maximum. Why? Because in time to come, the price of such stocks will only shoot-up. See here.

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6 Comments

  1. Great article but I am not a fan of diversification, and great companies are too not, like google developed the best search engine and monetized it, so did microsoft with windows, Apple with iPhone etc, and these companies are multibaggers. If I had picked any of these companies early, I would of held it for very long time and would have not diversified!.

  2. It is a great article in the right time and cautioned about stock market correction and stay away from peak market which may correct at any time is a good advice . Thanks a lot

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