Are you diversified enough?

About a year ago we put up a note on Personalfn discussing the benefits of investing in line with a well defined asset allocation plan. Then, investors were loading up on debt funds, Relief Bonds and other such fixed income instruments. We made a case for equities and building a well diversified portfolio. Our case was supported by numbers.

How times have changed since then. Today, investors are loading up on stocks and exiting fixed income instruments and debt funds as if there were no tomorrow. In view of this irrationality having once again taken a grip over many investors, we revisit the benefits of building a diversified portfolio.

We will also make a case for the relatively low risk debt instruments.

Let's take a look at the table below:

A diversified portfolio that was invested in January 1999, has earned about 10 per cent CAGR (as in Jan 04). What is noteworthy is that the stocks component (depicted here by the NSE Nifty) accounted for more than half the gains (about 47 per cent). This despite the fact that we have had a three-year bear market (2000-2002). Debt instruments accounted for about 30 per cent  of the gains.

Now let's look at the portfolio invested in January 2000, at the height of the tech led stock market boom. Here the contribution to returns is markedly different. Debt instruments accounted for 50 per cent of the gains. The contribution of stocks was about 25 per cent.

Also, the contribution of property and gold to overall gains is markedly higher despite a lower weightage (together about 23 per cent as against 12 per cent in the earlier instance).

Finally, in case of the portfolio invested in January 2003, over 85 per cent of the gains were contributed by the stocks component!

Some observations:

There is no one asset class which has performed consistently over the three different investment horizons that we have considered. The most volatile asset class has been stocks. The most stable, property and gold; and to a lesser extent debt.

Over the long term (the five year portfolio), the volatility in the performance of stocks evens out and it is the largest contributor to the overall gains (this despite the three year bear market).

Even though the stock and debt components account for a large chunk of the portfolio, gold and property play a significant role in years when either stocks/bonds don' perform well. The benefits of diversification are apparent.

A passive strategy can result in misallocation of assets resulting in significant 'unknown' risks. For example, in the first portfolio we started off with a weightage of 40 per cent to stocks. But by January 2004 this had grown to 47 per cent of the portfolio. In the portfolio invested in January 2003, the 40 per cent allocation to stocks had increased to over 51 per cent within a year!

If one were to keep these pointers in mind, building, and then sticking to, an asset allocation plan should not be a difficult task. However, and this takes us to the next issue, what does one do with an asset class which is in his plan but does not seem attractive from an investment perspective.

To discuss this further let's take the example of debt instruments in the present environment. Over the last six months income and g-sec funds have been disappointing performers.

This, coupled with the very low rates of interest on offer for fixed deposits, has pushed people to invest in monthly income plans (MIPs) from mutual funds. MIPs invest predominantly in debt instruments, keeping aside anywhere between 10 per cent and 25 per cent for investment in stocks.

While making this transition some investors do not realise that these products may not suit their risk profile. To earn better returns, they take on more risk i.e. a greater weightage to stocks in their portfolios.

In such times, it becomes pertinent that investors carefully study the asset class in question (in this case debt funds) to look for better opportunities. And not surprisingly there are some opportunities.

One option that is open to investors are the 'floating rate funds'. These schemes invest in instruments where the coupon rate i.e. the interest rate is not fixed. So if the interest rates in the markets move up/down, the coupon rate moves in sync. Therefore, there is no fear of erosion of the principal in case interest rates were to move up.

In an environment where it is likely that interest rates will rise or at best stay flat, there is a compelling investment case for these schemes.

Another option that is available to investors, especially now where the economy is gathering pace and corporate profitability has been rising, are debt mutual fund schemes which invest in instruments that are not of the highest quality (rated Sovereign, AAA, etc). These schemes invest part of their funds in higher risk debt paper (rated AA, A etc), which yield higher returns.

On top of this higher interest yield, in a buoyant economy there is a possibility that as profitability improves the credit rating of these companies would improve. A fund invested in paper whose credit rating improves gains significantly as the risk associated with it declines (so people bid up the price of the paper). (However, there are few schemes in the market today which follow this strategy.)

So before you decide to take a leap into equities, or for that matter into MIPs, revisit your asset allocation plan. In an environment where there is a lot of 'noise', your best bet could be a well diversified portfolio, which is in line with your risk profile.

Where are the stock markets headed? Click here to find out.