Diversification and Risk Management

Recently, I attended a session by an expert on good health.  I was pleasantly surprised to learn that besides diet and exercise, emotional and spiritual health is essential to a holistic lifestyle.

When there are many elements to achieving a certain goal, it is of primary importance that each of those elements is included and provided the necessary emphasis.  If we apply this concept to investing, there are so many stocks, categories, and sectors among the various styles, strategies, and themes that it becomes imperative to have the correct mix to help achieve a set investment goal.

This “correct mix,” or “diversification” in financial jargon, is an important technique that is one of the building blocks of a good investment strategy or portfolio.  Most strategies or portfolios aim to maximize return by taking on different exposures that have different characteristics.  The goal is to bring about varied results based on the different reactions to events that these characteristics display.  Let’s take the example of a buffet, which has an elaborate spread starting with salads, then appetizers, the main course, and dessert.  Often, there are local cuisines alongside international ones to provide for various tastes and cater to varied interests.

We can also extend this analogy to investing and indexing.  Depending on the preference or investment goal, a mix is selected in order to avoid overweighting or excessive exposure to one type of asset, stock, or sector.

Diversification can be a useful tool for reaching long-range financial goals while minimizing risk. Investment risk could be interpreted as the probability of suffering a loss, lower returns, higher volatility resulting in additional costs, etc.  The famous saying, “Don’t put all your eggs in one basket,” supports diversification.

Exhibits 1 and 2 help to explain diversification by comparing exposure to a single stock to an index. Exhibit 1 compares the returns of individual auto stocks (Tata Motors in brown, Hero Motor in green, and Bajaj Auto in purple) to the S&P BSE Auto (in blue).  Exhibit 2 shows the S&P BSE SENSEX returns (in blue) in comparison with individual stocks in the index (SBI in green, ITC in purple, and Infosys in brown).  The comparisons bring to light the volatility and risk of single-stock exposure, as they showcase high volatility along with a wide range of returns for the single stocks in contrast to the index, which had less volatility and a more narrow range of returns.

Exhibit 1: S&P BSE Auto Comparison 

Source: Bloomberg.  Data from March 2012 to March 2017.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

Exhibit 2: S&P BSE SENSEX Comparison

Source: Bloomberg.  Data from March 2012 to March 2017.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

These two cases are just examples, and there could be many other scenarios with different stocks, categories, sectors, styles, themes, etc.  Markets go through various cycles and trends, and not all favor any single asset class or category.  Let’s review the heat map for the period ending Dec. 31, 2016, which shows the difference in sector characteristics across time.

Source: Asia Index Pvt. Limited (www.asiaindex.co.in).  Data as of Dec 31, 2016.  Index performance based on total return.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

This provides clarity that diversification can hedge the risk of overexposure or bias.  Indexing can be a great route toward diversification, as indices are constructed to be well diversified by a neutral index provider.  Passive investing or investing in an index-linked fund may reap the diversification benefits of a varied exposure across stocks and sectors, potentially minimizing risk.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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