Diversification

Financial Planner: A diversified portfolio lowers your risk.

Reaction should be: Diversification won’t always save you – and you need more of it than you think. Your financial planner has to understand diversification across asset classes, geographies, business houses, industries, time horizons, etc. Not all financial planners are equipped to evaluate and advice on risk. That itself is the risk.

Diversification did not stop you from getting hurt in this downturn. All equity markets came down at the same time. If a company was doing badly its equity prices fell, ratings were re-done and bonds failed. So the de-coupling theory failed – stocks all over the world were done as were the bonds. AAA  failed. Ratings were a joke. Holding bonds did still leave you in the red. What happened? Jeremy Grantham, observed  had a bubble not just in one or two kinds of assets, but in risk. Investors around the world were so confident and willing to take risk for that extra little return that they were throwing money at anything that might deliver. And they were willing to leverage for that. Now that the risk bubble has burst, all those investors who were investing in gold, oil, movies, commodities, real estate and miscellaneous want now is the safety of Government Securities and Cash. So everything has moved in the same direction – debunking the asset allocation theory.

In my life of 30 years of seeing about the markets and reading about the markets and at a risk of sounding stupid, that these times are, to say the least, unusual. Over a longer period – as little as a decade – diversification across the world and asset classes still looks effective. While large U.S. stocks are down the past 10 years, U.S. corporate bonds earned 4.6% a year for the same period, Emerging markets did 18%, real estate should have done reasonably well for the past 10 years.

But in a fast paced economy where money moves quickly, and traders change jobs faster than changing shirts, you will have to work harder at diversification than before. Even great fund managers have done badly – Harvard and Standford endowment funds are down. A good definition of diversification for an international investor has to mean a lot more than the usual mix of U.S. blue chips, high-quality bonds, good European stocks, commodity companies from BRIC, and maybe some real estate in growing economies. It will have to include real estate investment trusts, emerging markets, and foreign and junk bonds. For Indians without too much of a want to look at international markets a combination of about 60% in Indian equities, 10% in foreign equities and the balance in debt schemes of the central government should work for time horizons of 12- 15 years.

Action Plan: To ensure you are diversified, please do not buy every NFO which comes your way. First, look at the funds you already have. Ensure you have large cap funds, mid cap funds and some international fund like Templeton Equity Income fund. It invests upto 35% of its assets in other country equities. Put that together with some public provident fund, arbitrage fund, and floating rate fund – at least for your emergency fund will give you a decent portfolio. For real estate however you need to go it alone. I have invested in a real estae spv but that is a private non-leveraged deal. The real protection is knowledge!