The two concepts of risk & return are closely related in investing. Usually, higher return investments also carry higher risk. Rational investors want returns to be as high as possible & risk to be as low as possible. What if we told you there is a way to lower your risk without lowering your returns? Too good to be true?
As per Modern Portfolio Theory, it is possible to achieve this using a collection of investments rather than a single investment. The lower the correlation between these investments, the lower the overall risk of such a collection of investments. This is called diversification, called the ‘only free lunch in investing’. To repeat, diversification is a way of lowering your risk while achieving the same level of returns.
To identify the ideal collection of assets i.e., the lowest possible risk for a given level of return, you would need to do a lot of complicated mathematical calculations analyzing historical rate of returns & volatility for various possible portfolios. You can take the help of a financial advisor or use the services of an app that provides financial guidance which have done the research on market data. Rather than getting into the construction of risk-efficient portfolios, let’s understand the deeper long-term benefits of diversification.
Let’s imagine two investors – Ms. D (who owns a diversified portfolio) and Mr. U (who owns a single asset). Both start their journey with an investment of Rs.1 lakh on 1st January 2012. The value of their respective investments moves like this chart below. As it turns out, both of them generated exactly the same total return over this 10-year period and both of their portfolios are worth exactly Rs. 4.1 lakhs 10 years later. But there’s a catch!
Do you think Mr. U would have stayed invested till the end of the 10-year period? What would you have done in his shoes when the market began to fall in 2013 or 2015? Many of us believe we are immune to fear, but find it very difficult to handle short-term losses in our portfolio. The real benefit of diversification is that it lowers the fluctuations in your portfolio and makes it easier for you to stay the course over the long-term.
The average investor in India has a hugely undiversified portfolio. For a middle-class salaried person, their residential home may be their biggest asset by far, followed by bank FDs, insurance policies and jewelry. While there is some diversification here, such a traditional investor would have earned very poor investment returns over the last 10 years. At Mighty, we believe that constructing an optimal diversified portfolio needs to be backed by serious research – best left to a trained financial advisor or a service like Mighty.
