Risk is an integral part of any investment. It can only be minimised, but can never be eliminated. Even in your most confident investments, you would always be subjected to market risk, however minute it may be. The higher the risk you assume, the higher the reward at the end of it. The additional return is the reward for undertaking non-diversifiable risk. Thus, we can safely assume that risk is part and parcel of an investment – and the most successful investments are those that have their risks managed efficiently. It isn’t just intuition or experience that helps develop such investments or portfolios; it is experience built on a strong understanding of diversification.

Don’t put all your eggs in one basket!

Diversification is important because it restricts the risks to spread across investments. Everybody seems to understand the need to diversify, but the problem is that most of us understand diversification only in its fundamental essence.

Conventionally, what one would infer by diversification is just buying varied, well-performing shares. That’s where the problem lies. Diversification is a much broader term. A diverse portfolio will constitute an equal distribution of low risk, moderate risk, and high- risk investments. Therefore, to have a truly diversified portfolio, one ought to have stocks, bonds, derivatives, gold, and possibly foreign exchange in their portfolio. This is rather easy to state, of course – and much harder to bring into effect. Thus, it is still essential to have a basic understanding of how diversification works. There are two basic aspects to diversification – the first talks about the different kinds of assets in a diversified portfolio, whereas the second measures the overall risk faced by the portfolio.

Pretentious Greek letters

Before classifying assets, it is crucial to understand the two kinds of risk that an investment faces in the markets – market risk and idiosyncratic risk. Market risk, as the name suggests, is the risk associated with the whole market; whereas, idiosyncratic risk is the risk associated exclusively to the asset/investment. For instance, for an investment in shares of Reliance, the whole market crashing due to an economic slowdown is market risk, while Reliance shares dropping in price due to a decrease in quarterly profits is an example of idiosyncratic risk.

Economists and finance intelligentsia are obsessed with Greek letters. They made use of alpha (α), which is used to denote the measure of investment return against market return. In simpler terms, alpha of an investment is the degree up to which an investment can outperform the market. When an investment earns higher returns than the market, the return is indicated by its alpha. For instance, if the market return is 10%, and the investment earns 11.25%, it is said to have an alpha of 1.25.

So, what’s an ideal alpha reading? An efficient, well-diversified portfolio should have a moderately high alpha (0.8-0.9). This means that substantial risks have been taken, but they are certainly not unrealistic. On the other hand, one should make sure that the alpha of the portfolio is not too low or negative; because that would mean that the portfolio performs worse than the market. Alpha is used to measure the performance of an investment and that of the portfolio against the performance of the market. It ought to be monitored regularly, as historical trends can always be subject to change.

Beta (β) measures an investment’s idiosyncratic risk against market risk. It is the indicator of an investment’s movement with respect to the stock market. A positive beta means that the investment moves in the direction of the stock market, whereas a negative beta means that the investment moves in the direction opposite to that of the stock market.

Hence, if an investment has a beta of 1.5, and the stock market earns a return of 10%, the investment will earn a return of 15%. Similarly, if an investment has a beta of – 1.5, and the market earns a return of 10%; the investment will fall in value or will earn a negative return of 15%.

It seems rather straightforward to have only those investments with a positive beta in your portfolio, and you’re all set. However, the truth is, negative beta investments are a crucial component of a diversified portfolio as well.

Consider this simplified chart showing the returns on the stock of Suzlon Energy Ltd, which has a positive beta of 1.5. The x-axis represents the rate of market return, and the y-axis represents the rate of return on Suzlon. At point A, when the market earns a return of about 9%, Suzlon earns 13.5%. It outperforms the markets when the market provides positive returns at B and C similarly. But when the market declines by 10% at point G, Suzlon registers a negative return of 15%. Similarly, at points F, E, and D – points with negative returns – Suzlon’s returns are worse than the market. The concept of having negative beta investments in your portfolio stems from the rationale of weighing risks and then spreading them across different investments.

Gold has traditionally been a negative beta investment. Consider this simplified chart showing returns on gold, which we will assume to have a negative beta of 0.5 (or -0.5).

When the stock market provides a return of 10% at H, the value of gold diminishes by 5%. Similarly, at points E, F, and G – gold gives a negative return when the stock market is performing well. Points A, B, C, and D represent periods of decline in the stock market. When the market generates a negative return of 10% at A, gold provides a positive return of 5% and similarly offers 3.5% at B, when the stock market return is negative 7%.

Hence, negative beta assets (gold + negative beta stocks) are crucial components of a diversified portfolio, given their beta is not very high. This is because they help set off the losses incurred on high, positive beta investments during market shocks and declines.

A negative beta asset is like insurance in the portfolio – it chips away at your gains when times are good, like an insurance premium; and when times are bad, it provides a stable return, moving against the declining stock market. So, when it comes to positive and negative beta assets in a portfolio – both are essential parts of it. It’s similar to choosing the vegetables for your Subway sandwich – you mostly put in everything, but then choose to leave out pickles or jalapenos, because you don’t want to take that risk.

Swiping right on the optimal portfolio The two broad kinds of assets aside, there are two more important factors affecting the correct portfolio for an investor – mathematical and personal. The mathematical quotient of it deals with the concept of covariance, which is a measure of the degree to which these assets move in tandem with each other. Covariance is just the relationship between two assets that measures the volatility of one asset with respect to the other.

Covariance is said to be positive when there is a direct relationship between the two assets (A increases, B increases). Negative covariance entails an inverse relationship between assets (A increases, B decreases). The covariance between assets affects the overall variability of the portfolio. This means that the covariance between assets in a portfolio will determine the stability of that portfolio. Covariance, thus, determines overall portfolio volatility.

If there is a positive covariance between shares of the State Bank of India and ICICI Bank, say 0.7; it means that a rise in the value of SBI shares is almost always accompanied by a rise in the value of ICICI shares. So, the prices of both these stocks move in the same direction. Suppose there is a negative covariance between shares of the Oil and Natural Gas Corporation, and Suzlon Energy Ltd, of 0.8. This implies that if the price of ONGC moves up, the price of Suzlon shares will decline; and the other way round. These prices move in opposite directions. However, a high positive covariance is not good for the portfolio either because it undermines the portfolio’s stability. This is because the value of these assets will move in the same direction, both upward and downward. For instance, if you invest in ICICI and SBI shares and there is a market slump in the banking industry, one’s chances of redemption at that point are fairly minimal.

Negative covariance – up to an extent – can help stabilise the portfolio. If the asset values move in opposite directions, the loss incurred in one is set off by the gain from the other. It is mostly just prudence. If you invest in ONGC and Suzlon and ONGC falls in value, Suzlon’s value is likely to rise and help prevent major losses. This calculation of covariance isn’t just for stocks. It can be applied to bonds, gold, and other investments as well.

The personal factor of an investment analysis refers to the investor’s position. It isn’t always ideally possible to diversify efficiently. Both the individual investor’s willingness and ability to take risks affect how diverse their investments will be. Consider three different investment portfolios in two avenues:

75% real estate, 25% stock

50% real estate, 50% stock

75% stock, 25% real estate

A is the safest, B is a prudent approach, and C is the riskiest. Does this mean that opting for B is the best way available? Not necessarily. You still sacrifice some return when you opt for B. Based on the two traits listed above, different investors have different objectives and the ideal, diversified portfolio varies from person to person. In fact, two investors with the same means may have radically different portfolios that may each be well-diversified, and they may end up earning the same return.

In conclusion, one can safely assert that a portfolio depends on what the investor wants from it, and how much risk they are willing to take. But it is imperative to make sure that an investment is made with a strong sense of diversification. This diversification doesn’t require superior intellect, it requires a meticulous and disciplined effort. Discipline trumps intelligence in the long run.

By Parth Kulkarni

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