Diversifying Investments In India: Strategies For Success

Diversifying your investments is a crucial aspect of financial planning and portfolio management. By spreading your investments across different asset classes, you can minimise risks, protect against losses, and enhance your portfolio returns. In India, investors can easily diversify between traditional asset classes such as equity, fixed income, and gold. Mutual funds offer a convenient platform for constructing diversified portfolios, providing low investment thresholds and high liquidity. However, it is important to guard against over-diversification, which can dilute the performance of your best investments. The key is to find the right balance between different asset classes, sectors, and investment instruments to achieve your financial goals.

Diversify within asset classes

Diversification within asset classes is a crucial aspect of financial planning and portfolio management. Here are some ways to diversify within asset classes in India:

Fixed Income

Fixed income or debt instruments are generally considered the lowest-risk asset class. Within this class, investors can further diversify by investing in a mix of risk-free assets, such as bank fixed deposits and government savings schemes, and other options with varying levels of credit and interest rate risks, such as company fixed deposits, debentures, and debt mutual funds. The key is to strike a balance between different duration profiles, from short-term to long-term, to meet liquidity, risk, and return objectives.

Equity

Equity carries the highest risk among asset classes but also offers the potential for higher returns. To diversify within this class, investors should aim for a mix of large-cap, mid-cap, and small-cap stocks or mutual funds. Large-cap stocks, such as those from well-established companies, tend to be less risky, while small-cap and mid-cap stocks are more volatile but may offer higher returns. Diversification across different sectors and industries is also essential to reduce unsystematic risk.

Gold

Gold sits between fixed income and equity in terms of risk. As an asset class, gold has historically provided potential returns over very long investment horizons (e.g., 10 years or more) and is often seen as a hedge against inflation. However, gold can also underperform fixed income for extended periods. Therefore, investors should consider their investment horizons and overall portfolio mix when allocating to gold.

Mutual Funds

Mutual funds offer an accessible way to diversify within and across asset classes. Equity mutual funds, for instance, can provide exposure to a range of stocks and sectors, reducing the risk of individual stocks or sectors underperforming. Similarly, fixed-income mutual funds offer various products catering to different investment needs, tenures, risk appetites, and liquidity requirements. Hybrid funds also allow investors to gain exposure to both equity and fixed-income asset classes.

Other Asset Classes

In addition to the traditional asset classes of equity, fixed income, and gold, investors can consider newer options like InvITs (Infrastructure Investment Trusts), REITs (Real Estate Investment Trusts), and unlisted investments. However, these alternatives may require more research and carry different risk-return characteristics. For example, REITs and InvITs may provide regular income but are susceptible to capital erosion due to interest rate changes, while unlisted investments may offer high returns but also carry a higher failure rate and illiquidity risks.

Diversify across asset classes

Diversification is a key component of intelligent investing. The old adage, "don't put all your eggs in one basket", is the essence of diversification in financial planning.

In India, investors can diversify their portfolios by allocating money across different asset classes, such as equity, fixed income, and gold. Mutual funds provide a convenient platform for investors to construct a diversified portfolio of equities and fixed income investments, offering low investment thresholds and high liquidity.

Fixed Income

Fixed income or debt instruments are typically the lowest-risk asset class. Within this category, risk-free assets like bank fixed deposits and government savings schemes offer the lowest risk but also the lowest returns. Company fixed deposits, debentures, and debt mutual funds carry varying degrees of credit and interest rate risk, with lower-rated instruments offering higher yields but also higher risk.

Gold

Gold is considered a step higher than fixed income in terms of risk. Historically, gold has provided higher returns than fixed income over very long investment horizons (e.g., 10 years) and is often seen as a hedge against inflation. However, gold can underperform fixed income for extended periods, so investors need to have a long-term investment horizon.

Equity

Equity carries the highest risk among all asset classes but also offers the potential for the highest returns over the long term. Equity investments are much more volatile than fixed income or gold. Different types of stocks will have different levels of volatility, and it is important to assess the qualitative risks of a stock before investing.

Mutual Funds

Mutual funds are a popular option for diversifying across asset classes. They allow investors to access a diversified portfolio of securities with a relatively small investment. Hybrid funds, for example, can provide exposure to both equity and fixed income asset classes. Mutual funds also help to diversify company concentration risk and sector risks by investing in multiple industries and market capitalizations.

Global Diversification

In addition to diversifying across asset classes within India, investors can also consider global diversification. This involves investing in international markets and currencies, which can provide access to different sectors and potentially higher returns. However, global investing also carries additional risks, such as currency fluctuations and country-specific risks.

By diversifying across different asset classes, investors can balance risk and return to achieve their financial goals. It is important to note that the level of diversification should be appropriate for the investor's goals and risk tolerance, as over-diversification can dilute the performance of the best-performing investments.

Understand the risk-return profile of different asset classes

Understanding the risk-return profile of different asset classes is crucial for investors looking to diversify their portfolios and manage their overall investment risk. The three primary asset classes are traditionally stocks (equities), bonds (fixed income), and cash equivalents or money market instruments. However, nowadays, investment professionals also include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies in the mix. Each of these asset classes carries its own unique risk-return profile, which is influenced by factors such as investment structure, market capitalization, and liquidity.

• Equities (Stocks): These are considered riskier than other asset classes but offer the potential for higher returns. Stocks represent ownership in a company, and investors purchase them in hopes of earning profits through capital appreciation or dividend payments. The market for stocks can be volatile, with share prices fluctuating and some companies even going bankrupt.
• Fixed Income (Bonds): Fixed-income investments, or bonds, are generally considered less risky than equities but offer lower potential returns. They are debt instruments issued by governments or corporations, which pay regular interest payments and return the principal amount upon maturity. The risk of certain governments defaulting on their bonds is very low, so they offer lower returns, whereas some companies may go bust, so they need to offer higher returns to attract investors.
• Cash and Cash Equivalents: This asset class includes highly liquid investments such as money market funds, certificates of deposit (CDs), and savings accounts. They are considered low-risk and provide little to no potential for capital appreciation, making them ideal for short-term investment goals.
• Real Estate: Real estate investments can provide a steady income stream and long-term appreciation but come with risks such as market fluctuations and maintenance costs. They can include physical property or investments in real estate investment trusts (REITs) or real estate mutual funds.
• Commodities: Commodities are physical goods such as oil, gold, or wheat, which can be traded on commodity exchanges. They can be a hedge against inflation and market volatility, but they are also subject to supply and demand fluctuations. Commodities are crucial to the economy, and many investors invest in them indirectly by buying shares in companies that produce them.

It is important to note that historical performance does not guarantee future results, and different asset classes may outperform each other in different economic cycles. For example, fixed income may outperform equities in bear markets, while equities may outperform in bull markets. Therefore, investors should carefully consider their investment goals, risk tolerance, and time horizon when deciding how to allocate their investments across these asset classes.

Diversify across sectors, business cycles, and company sizes

Diversifying your investment portfolio is a sensible strategy to reduce risk and volatility. This is true in India as it is anywhere else.

In India, investors can diversify across the traditional asset classes of equity, fixed income, and gold. Mutual funds are a convenient way to construct a diversified portfolio of equities and fixed income, and they offer low investment thresholds and high liquidity.

However, investors may need to spend more time researching newer asset classes such as InvITs, REITs, and unlisted investments.

• Inter-asset class diversification: Diversify across sectors, with a mix of large and mid-sized companies. Some sectors may be booming while others are in decline. Financial innovations such as ETFs for equity, fixed income, and gold have made it easier to create a diversified portfolio within each asset class.
• Global diversification: Global investing can be seen as diversification across countries and currencies, business cycles, earnings cycles, sectors, and tax regimes. While this can be a good strategy to gain access to new sectors and markets, it also carries additional risks, such as currency fluctuations.
• Macroeconomic cycles: Different countries are often in different stages of the economic cycle (boom, recession, depression, recovery). Allocating investments across global macroeconomic cycles can potentially orient a portfolio towards global growth.
• Earnings cycles: A similar strategy can be applied within a sector. For example, the earnings drivers for US tech companies are different from those of Indian tech companies. An investor allocating across both can benefit from the diversification of the two earnings cycles.
• Valuation cycles: Countries also go through different stages of current valuation vs historical valuation. Global diversification allows investors to diversify across these valuation cycles.
• Sector diversification: An Indian investor may find fewer domestic opportunities in sectors such as consumer tech, AI, and semiconductors. In these cases, a global portfolio can provide access to new sectors while also diversifying risk.
• Availability: Indian investors can use feeder funds or the Liberalized Remittance Scheme (LRS) route to invest in global funds, stocks, bonds, or managed accounts.
• Low correlation: Major global indices (S&P 500, Nasdaq, China, and Europe) have a low correlation with India's Nifty500, ranging from 0.49 to 0.63. This means that investing in these global indices can further diversify an Indian investor's portfolio.

Choose between global and domestic diversification

When it comes to choosing between global and domestic diversification, there are several factors to consider. Here are some key points to help you make an informed decision:

Global Diversification:

• Global diversification offers access to high-quality businesses and growth sectors that may be absent in India, such as AI, gaming, robotics, and semiconductors. Investing in these sectors provides both the benefits of diversification and contributes to higher growth.
• By investing globally, you can gain exposure to well-known global brands and innovative companies, such as Apple, Samsung, Amazon, Netflix, Google, Facebook, and Tesla. These companies are not available for domestic investment in India but are shaping the global economy.
• Global diversification helps protect against the risk of rupee depreciation. The Indian rupee has historically depreciated against major global currencies, and this trend is likely to continue. Investing in foreign assets can hedge against currency risk.
• Global stocks can offer higher returns at lower valuations compared to the Indian market. For example, Pfizer India trades at a higher price-to-earnings (PE) ratio on the NSE compared to its US counterpart, despite the US business being larger and more profitable.
• Stocks in developed markets tend to be more stable than those in emerging markets due to heavier regulation and stronger corporate governance structures. This can provide a more level playing field for investors.
• Global diversification allows you to participate in global trends and advancements in technology, virtual workplaces, virtual shopping, and increased spending on communications.
• Global investing provides access to a wider range of sectors and companies, such as Microsoft, Apple, Amazon, and Facebook, which have benefited from recent global shifts.

Domestic Diversification (India-specific):

• The Indian market has strong economic growth and solid fundamentals, making it an attractive investment destination.
• Investing domestically can be more convenient due to familiar regulations, easier remittance processes, and lower transaction costs.
• Domestic investments may provide better insight into local market dynamics and industry-specific factors influencing stock performance.
• India-specific investments can be more closely aligned with local economic growth and development plans, allowing investors to benefit from the country's potential.
• Domestic diversification may be suitable for investors with a lower risk appetite or those who prefer to invest in familiar markets.
• Certain sectors in India, such as pharmaceuticals, education technology, and information technology, have been among the best-performing sectors, especially during the Covid-19 pandemic.

In conclusion, both global and domestic diversification have their advantages. Global diversification offers access to a wider range of opportunities, helps hedge against currency risk, and allows investors to participate in global trends. On the other hand, domestic diversification in India can provide a more focused approach, leveraging the country's strong economic growth and industry-specific advantages. The ideal approach is often a combination of both, creating a well-diversified portfolio that balances risk and return to achieve your financial goals.

Frequently asked questions