When it comes to investments, the adage, ‘Don’t put all your eggs in one basket’, comes to mind. Diversification essentially means the strategic allocation of investments among different assets and their categories to spread the money around so that exposure to any one type of asset is limited. This helps manage risk and reduce volatility of portfolio over a period of time. One of the keys to successful investing is to learn the art of maintaining fine balance between comfort level and time horizon.
If one invests conservatively for retirement at a young age, he/she may run the risk of investment growth not keeping pace with inflation. Conversely, if one invests too aggressively, when one is older, they may face a situation where their savings are exposed to market volatility. This can erode the value of their assets at an age when one has fewer opportunities to recoup losses.
One way to balance risk and reward in an investment portfolio is to diversify assets. Although diversification does not ensure profit or guarantee no losses, it may help mitigate risk. It does help in reducing the number and severity of ups and downs. Diversification does not aim to maximise returns but limits the impact of volatility on a portfolio. To better understand this concept let us look at the table along with this article which contains hypothetical portfolios with different asset allocations from 1926 to 2017.
The most aggressive portfolio shown in the table comprises 60 per cent domestic stocks, 25 per cent international stocks and 15 per cent bonds. It has an average annual return of 10.02 per cent. The best 12-month return stood at 134 per cent, while its worst 12-month return lost nearly by 61 per cent. This is too much of volatility for investors to endure.
However, as we can see, a slight change in the asset allocation tightened the range of those swings. It is also clear that additional fixed income investments to a portfolio slightly reduces one’s expectations for long-term returns. But this may significantly reduce the impact of market volatility. This is a trade-off many investors feel is worthwhile, particularly as they get older and more risk-averse.
Factoring time into diversification strategy: People are generally accustomed to thinking about their savings in terms of goals —retirement, college, a down payment or a vacation. But as one builds and manages his/her asset allocation, regardless of which goal he/she is pursuing, there are two important things that must be considered: First, the time horizon ie the number of years when one would need the money back and second, attitude toward risk.
To take an example, a young adult may think of a goal that is 25 years away, like when he/she retires. Since the time horizon is fairly long, he/she may be willing to take additional risk in pursuit of long-term growth. The investor may be under the assumption that there’s enough time in hand to regain lost ground in an event of short-term market decline. In that case, higher exposure to domestic stocks may be appropriate.
However, risk tolerance plays a crucial role here as well. Regardless of the time horizon, one should undertake risk with which he/she is comfortable. So even if one is saving for a long-term goal, or is more risk-averse, he/she may want to consider a more balanced portfolio with some fixed income investments. Regardless of the time horizon and risk tolerance, even if one is pursuing the most aggressive asset allocation model, he/she may want to consider including a fixed income component to help reduce overall volatility of the portfolio.
The other thing to remember about time horizon is that it keeps changing constantly. So, let’s say one’s retirement is 10 years away, he/she may want to re-allocate their asset to help reduce exposure to higher-risk investments in favour of more conservative ones like bond or money market funds. This can help mitigate the impact of extreme market swings on portfolio, which is important when one needs the money relatively soon. Once they enter retirement, a large portion of the portfolio should be more stable. Lower-risk investments can potentially generate income. But even in retirement, diversification is key to help manage risks. So just as one should never be 100 per cent invested in stocks, it’s probably a good idea to never be 100 per cent allocated in short-term investments if time horizon is greater than one year.
After all, even in retirement one needs exposure to growth-oriented investments to combat inflation and help ensure that the assets last for what could be a decades-long retirement. Regardless of the goal — time horizon or risk tolerance — a diversified portfolio is the foundation of any smart investment strategy.
(The writer is Assistant Professor, Amity University)