By Ranjeet S Mudholkar
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield optimally desired returns while lowering a risk that is posed by any individual investment found within the portfolio.
It holds special significance in the financial planning process where the emphasis is on achievement of life goals through proper planning of one’s finances. The goals are achieved through investment in various asset classes over the lifetime of an individual and a proper analysis of the same needs to be done before allocating a specific proportion of portfolio to one particular asset class. There are many parameters on which asset classes for investment are judged, the major ones being the following
a) Safety( Volatility)
c) Growth( Returns)
e) Time Horizon
Financial goals are both long term and short term in nature. The long term goals include retirement, children education and marriage while short term goal may include going on vacation, buying a luxury car etc. Similarly different asset classes have different horizon of time in which their returns are optimized. It is always wise to match the asset classes with the financial goals to the extent possible.
The table below gives the return from different asset classes over the 11 year period.
Looking at this table, it can be said that there are many instances where one or more asset classes have given negative returns, but it can be clearly seen that all asset classes are not negative during the same period and thus combining some or all of them judiciously in consultation with an expert shall ensure that portfolio returns are optimized and steadied during the investment horizon.
According to a study conducted in USA in 1986 by Gary P. Brinson, L Randolph Hood and Gilbert L. Beebower, asset allocation is responsible for 90% or more returns of the portfolio, many theories have come subsequently which talk about the same.
Thus diversification entails proper asset allocation and it must be that noted that asset allocation is very dynamic in nature and needs continuous monitoring and marking to the market.
In addition to the diversification across asset classes, it is also advisable to diversify within asset classes also with respect to other factors. Another way of diversification can be buying different category of same asset class, if somebody already has residential real estate, then buying commercial real estate would be a wise idea to ensure that the yield is also commensurate with the investment.
Since the achievement of financial goals is a lifelong process, it is advisable to invest in the asset classes over a period of time instead of a single point investment will ensure that one can average out the fluctuation in asset prices and the average buying price will be lower than the market price. This principle is called Rupee Cost Averaging and an example of the same would be Systematic Investment Plan (SIP) of a mutual fund.
Diversification in Space (Geographical Diversification)
In location specific asset classes particularly real estate which holds the highest proportion of net worth of an individual in general, it is very important to ensure that the property is protected against natural perils like flood. If somebody has a property in areas prone to natural disasters like earthquake or flood and is planning to buy a second property, then it should be done in an area which is relatively safe. This will ensure that in case of natural calamity at one place some part of the capital is safe.
In addition to protecting the portfolio against risk of loss, diversification may also make the investment tax efficient. There are some asset classes like equity and equity schemes of mutual funds, gains on which are exempt in long term and short term capital gains are charged at a subsidized rate of 15%. While Investing in debt schemes of mutual funds one can take the benefit of indexation, any capital losses accruing out of investments can be offset against capital gains from similar investments for a period of 8 years as per Income Tax Act. The insurance portion of the portfolio provides tax benefits under section 80C of Income Tax Act.
A proper asset allocation also ensures that the journey towards the achievement of financial goals stay on course, at the same time there should be no crunch of resources for short term fund requirement. It is therefore advisable to keep some amount in cash or cash equivalents which is close to eleven months of expenditure of an individual. Investing in liquid schemes of mutual funds can be a good option in this case.
Thus it can be seen that a well diversified portfolio in all aspects across and within asset classes will ensure the achievement of financial goals.
It is important to note here the advice of a expert like a Certified Financial Planner or CFP professional should be sought to ensure that the journey towards financial goals start well and stays on course.
Ranjeet S Mudholkar, is Vice Chairman and Chief Executive Officer, Financial Planning Standards Board India (FPSB India). The views expressed here are personal, and do not necessarily represent that of the organization.