In 4 steps to creating a portfolio, we wrote about the need for an asset allocation. In Get smart with your asset allocation, we went one step further and explained the need for diversification while differentiating between asset allocation and diversification. Here we look at three common errors committed in this arena.
Mistake 1: Overestimating the level of diversification
Let's say you opt for a 65% allocation to equity, and within that asset class have around 12 equity funds. You may be smugly satisfied at the thought of being amply diversified. You are wrong. But take heart, you are not alone. Christine Benz, Morningstar’s director of personal finance based in Chicago, says that for every single portfolio she receives that is whippet-thin -- without an excess stock, fund or ETF to spare – she comes across 10 more that have 50, 60 or even 100 individual holdings. She refers to over diversification as portfolio sprawl and believes that it can add to investors' oversight challenges.
You may find nothing wrong with it, but there is a practical risk to being too diversified. With an abundance of stocks and funds in one’s portfolio, it becomes nearly impossible to get a good knowledgeable grasp on each holding. When you lose your focus, you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things.
Diversification tends to become a problem when investors get carried away and buy on whims or fall for the latest market craze. Splintering your portfolio into too many different funds and can dilute the impact of any one investment. An overdiversified portfolio can stunt returns and amplify risk. By blindly assuming more is safer, overdiversification gives a false sense of security.
What must you do? Look for duplication and cut off the excess. You really do not need numerous mid cap funds. Neither do large cap funds in your portfolio need to co-exist with the index funds which track the Nifty and Sensex. Too many sector funds is also not a smart move.
Mistake 2: Excluding an international exposure
When investors talk about asset allocation and diversification, they instantly think equity and debt and a further break-down within these categories. The more sophisticated (and wealthier) ones will go one step ahead and think along the lines of property and art.
But by ignoring global investing, when planning for diversification, investors are using only a fraction of the weapons in their investing arsenal. By investing globally, an investor can benefit from various geographies and stocks across different markets.
Moreover, there is no certainty that a particular market performing well presently will continue to outperform every year on a regular basis. Hence, there is no logical reason to only be invested in one single economy.
Emerging markets expert Mark Mobius did a study of 72 stock markets over 25 years. He found that there was not a single market that was the best performing one over two consecutive years. And only one market was the best performing in four of those 25 years; Turkey.
In 2013, the U.S. stock market soared. The Dow and S&P 500 posted the biggest annual gains since the late 1990s. The Dow was up 26% and the S&P 500 gained more than 29%. The Nasdaq has surged nearly 40%, to highs not seen since 2000. This feat was not repeated the next year, though the market rose. In 2014, the Dow was up 7.5%, the S&P 500 11.4%, and Nasdaq 13.4%. Extend this argument to India. In 2011 when the domestic stock market was battered, a marginal exposure to another geography would have helped curb the hit a portfolio would have taken.
From a risk and a returns perspective, it makes a lot of sense to diversify your investments geographically. It helps you benefit from other geographies and stocks that are not available for investment in India.
What must you do? Check out the various global funds available. Some will be sector funds – gold, mining, commodities, agriculture and energy. Others focused on a geography - Europe, Asia, Brazil, China, Japan or the U.S. Preferably opt for the latter and avoid the sector funds, unless you have a strong view on them and they fit in with your overall portfolio.
Mistake 3: Opting for a standard asset allocation
No preset allocation or tool can possibly address the many variables that factor into an appropriate asset-allocation framework.
A 62-year-old with limited investment assets and poor health who intends to retire next year will, very likely, need to invest differently than a wealthy entrepreneur of the same age and expected retirement date.
This concept holds true from the standpoint of job stability, as well. A college professor in a reputed institution with a stable job could afford to have a more aggressive asset-allocation mix than someone in a profession with a more volatile income stream.
The volatility in the income stream of a commission-based salesperson or an entrepreneur starting out might call for a larger emergency fund than the typical three to six months’ worth of living expenses. The asset mix would also depend on whether or not the spouse has a steady income, how large it is, and if there are other sources of cash flow such as rental income.
What must you do? It would be wise to sit with a financial adviser to arrive at a customised asset allocation keeping your goals in mind.
