How to Diversify your Portfolio for Better Returns: Part 2

In our last Blog Post, we discussed diversification in terms of Bank Deposits or Mutual Funds only, along with percentages you may allocate to them.

In this article, we will not be telling you any percentage allocation because it is YOU who have to decide how much to invest and where – based on your risk profile – Conservative, Moderate or Aggressive.

Diversification

Given that the word Diversification is tossed around so much, we must know why it is necessary. It’s because any SINGLE asset class is affected by other factors such as expected interest rate rises, political tensions, debt concerns, and trade negotiations but a diversified investment reduces the volatility.

Appropriate diversification is VERY important, in terms of returns as well as peace of mind. The problem with financial products that ADVERTISE diversification is that they:

  • Don’t provide effective diversification,
  • Won’t protect Investor from market volatility
  • Have high fees attached
  • Sometimes including the commission for the salesman/agent

Even for DIY/Retail investor issues with the perception of diversification is:

  • Over-diversification – According to E.J. Elton and M.J. Gruber most of the benefit of increased diversification can be obtained with a portfolio which has between 20 and 30 securities in it. Despite this, most mutual funds hold between 50 and 150 stocks in them, and a lot of investors (way more than you think) hold multiple mutual funds (as high as 25 FUNDS), multiple ETFs (which are just collections of stocks themselves) and multiple stocks all in a single portfolio.
  • Perfectly Uncorrelated Asset Classes – When markets are falling — collapsing as they did in 2008 and 2009 — diversification provides no benefit. But people think that they are invested in Stocks AND Bond AND both are 100% uncorrelated hence their investment return would remain positive. That does not work like that, two or more asset classes will be correlated to some extent (no matter less or more).

Where to invest?

Investments in each of these different asset categories will do different things for you.

  • Stocks help your portfolio grow.
  • Bonds/Debt bring in income.
  • Real estate provides both a hedge against inflation and low “correlation” to stocks—in other words, it may rise when stocks fall.
  • International investments provide growth and help maintain buying power in an increasingly globalized world.
  • Cash gives you and your portfolio security and stability.

Money Pie

NOW THE ACTUAL DIVERSIFICATION (sort of plan) WE WERE WAITING FOR (this is an activity and you should do it actively – with pen & paper or MS Excel or anywhere)

How do you figure out how much money to put into each asset class?

  • First, set aside enough money in cash and income investments to handle emergencies and near-term goals.
    • Thumb rule in India is 6 months. If YOU earn 6 LPA, you should have at least 3 Lacs as Cash (Saving Account, FD, RD etc).
  • Second, plan more risky investments by using the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds.
    • For example, if you’re 30 years old, put 70% of your assets in stocks; 30% in bonds.
  • Third, 5% from stocks and 5% from bonds in Real Estate.
    • The scenario now changes to 65% stocks, 25% bonds and 10% Real Estate (for a 30-year-old).
  • Fourth, from stocks invest 10% to 25% in INTERNATIONAL/Foreign funds. The investment is inversely proportional to age. Younger to invest 25%, elder to invest lower and lower.

Why we have not gone in much more detail is because Diversification should be based on an Individual’s need. And only YOU know what you need and how comfortable you are diversifying.

Warning

We believe you should avoid or take care of these things:

  1. First and Foremost – NEVER invest in anything you cannot explain to yourself or your kid (you should know how and why Stocks behave in a way they do)
  2. Investing without knowing WHY – Always assign the goal to your investment. Car purchase, home purchase, children’s education and marriage, retirement, vacation planning etc.
  3. Too many investments – 25 Funds and 75 individual stocks – Not going to help you in any way.
  4. ONE TIME INVESTMENT or Invest and forget strategy – it’s your money – re-balance your portfolio once a year (at least). Different asset classes move differently, if you started with 65%, 25%, 10% in Equity, Bond, R. Estate, maybe next year it changes to some other combination with respect to total value. You need to sell or buy accordingly and maintain your portfolio allocation.
  5. ONLY long term in commodities.
  6. Avoid foreign stocks and funds – Only in case of USA listed companies (US-listed companies are mostly present across the globe, their business is affected by all marketplaces)
  7. Using market cap as a yardstick – In very good times and very bad times small cap, mid cap and large cap all behave similarly.
  8. High price and illiquid investments (especially in short-term) – real estate specifically.

We believe that this will at least give you a fair idea about how diversification works and you may take first steps towards it.

You may like to read this Quora answer by one of our members – http://qr.ae/TUGi8D

References:

TUI – Team

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