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The related concepts of portfolio diversification and asset allocation are simple in essence. They are based on the fact that various financial assets often move out of step with each other. If you hold a mix of diverse assets, some part of that portfolio will deliver returns, under most conditions.
One can understand how diversification affects risk by considering extreme cases. Say, somebody puts all his resources into one business as entrepreneurs often do, at start-up. Such an extreme focus can make you very wealthy - think Bill Gates or Oprah Winfrey. It could also make you broke and that is more likely since hundreds of startups go bankrupt for every Microsoft. So a narrow portfolio is high-risk and potentially high-reward.
At the other extreme, consider a mutual fund portfolio that holds all heavily traded stock. The returns mirror the stock market. Add a broad set of debt funds. The returns of this equity+debt portfolio mirror the entire capital market. The diversification can be extended to include commodities, bullion, real estate, currencies, etc to mirror the whole range of financial assets.
Between these extremes, investors can hold different assets in varying proportions to generate reasonable returns while reducing risk. The key lies in understanding how correlated the assets are.
There"s not much risk-reduction in buying similar or related businesses - their fortunes wax and wane together.
However, two industries with different dynamics can offer inverse correlation. Auto stocks for example, often do badly when oil producers do well. That"s because high fuel prices inhibit demand for new cars. There are also zero correlation situations. Returns from agro-commodities like sugar, or tea, may have little to do with the broad economy.
In terms of asset classes, equity and interest rates are inversely correlated. Higher interest rates can hurt equity valuations. Commodities can show high,.low or no correlation to equity or interest rates – it depends on the commodity. Base metals tend to be positively correlated to equity. Bullion tends to be positively correlated to interest rates. Gold spikes when interest rates are high.
Even with an understanding of basics, how does one allocate assets? It depends on the desired risk profile. Some experienced and successful investors, including Warren Buffett, avoid wide diversification. They prefer concentrated bets in a few assets, carrying relatively narrow portfolios, and accepting higher risks in the hopes of generating higher returns.
The approved wisdom however, is to hold a broad set of assets and tinker as little as possible. This is the life-cycle approach. The idea is, set long-term targets and build a portfolio to meet those targets without taking excessive risks. Once that portfolio is in place, only rebalance when life-cycle goals change.
For example, a young man is usually advised to be overweight in high-risk assets like equity. Somebody close to retirement age should be more inclined towards income instruments that don"t put principal at risk.
This passive broad approach relies very heavily on the law of averages. Sometimes business cycles are out of the norm in terms of length or severity. A long recession like Japan"s 19-year bear market could kill a life-cycle approach. Equally, a Brazil-style high-inflation, high-growth environment would make a mockery of debt-heavy allocation. The worst case scenario with any portfolio is stagflation. In such a situation, only buying bullion, or going overseas, seems to work.
Any asset allocation strategy should take current market conditions into account and make some judgement call on how long those conditions may last. In India, and other volatile developing economies, returns from a given asset can vary massively year-to-year and indeed, quarter-to-quarter. An Indian investor should therefore be prepared to review asset allocation fairly often and to rebalance around one-third or more at a single go, if alarm bells go off. As of now, it"s a strange situation. It"s early into a bull market but equity looks dangerously over-valued at a Nifty PE of 22.
Unfortunately most debt assets also look dangerous since inflation has zoomed. Bullion is at highs that makes it somewhat unattractive. It"s one of those situations when asset allocation is quite difficult. Investing in bond funds will almost certainly lead to a loss of principal if rates climb as they"re threatening to do. Equity could actually be safer. There is a chance that growth may accelerate and reduce valuations without there being a major price correction.