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Benefits of Portfolio
Diversification
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In
many cases, it is beneficial for equity investors to diversify across companies and industries to
mitigate risks. For most investors, diversification is the simplest and
cheapest way to risk mitigation. Diversification is an established tenet for conservative
investors and it is especially helpful when the returns of two or more
investments are perfectly negatively correlated, resulting in substantial risk
reduction. Negative correlation expresses the inverse relationship between the
returns of two securities – which means their returns move in opposite
direction.
On
the contrary, in cases when returns of two investments are perfectly positively
correlated, diversification will not provide risk reduction, only risk
averaging. Positive correlation indicates that the returns of two securities
move in the same direction – that is, they tend to go together. If the return
of one security goes up, the return of the other security also tends to
increase and vice versa.
Diversification
can substantially reduce security-specific risk, but not market risk. That is
why for a well-diversified portfolio, security-specific risk is practically
insignificant.
Some
sophisticated and institutional investors go for international diversification,
investing in securities in different countries. Of course, they have to take
care of political risk and currency risk involved in such international
securities.
Institutional
investors broadly consist of pension funds, sovereign wealth funds, endowments,
insurance companies, banks and other financial institutions.
Over-diversification
is detrimental to an investor’s wealth. So is under-diversification. Many
investors hold 15 to 30 different mutual fund schemes. A mutual fund itself
holds a number of securities. So it does not make any sense to hold more than
three or four mutual fund schemes belong to a particular asset class. For
example, it is better to stick to holding not more than three or four equity
schemes under equity asset class.
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Portfolio Rebalancing
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Suppose
an investor in 2012 has 40 per cent of his assets in equities, 20 per cent in
bonds, 35 per cent in real estate and 5 per cent in gold. After one year assume
that the investor’s asset mix changes as – equities 50% and bonds 10%; while
real estate and gold remain the same proportionately. So in 2013, 10% of the
wealth can be sold out of equities and the same can be ploughed back to bonds
to restore the original balance in the total portfolio. This is called
portfolio rebalancing.
Several
mutual funds do this type of portfolio rebalancing through funds such as,
balanced/hybrid funds, asset allocation funds and funds of funds. Some
sophisticated and knowledgeable investors do portfolio rebalancing every year
on their own.
Related: Understanding Asset Allocation 14Oct2012
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Disclaimer:
The author is an investment analyst, equity investor and freelance writer. This
write-up is for information purposes only and should not be taken as investment
advice. Investors are advised to consult their financial advisor before taking
any investment decisions. He blogs at:
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