Diversification is a term bandied about in the investing realm, but people cannot really figure out how to do it correctly. Does investing in 100 stocks count as good diversification? Or should one buy every available asset class to ‘diversify’? Even financial planners cannot agree on the right strategy to allocate investments. This is why we will study actual returns from various asset classes to determine what kind of diversification is good.
To start with, we will take four asset classes—domestic equities represented by the Nifty 200 total returns index (N200), debt represented by gilt schemes investing in government securities (GSEC), gold represented by exchange spot prices (GOLD) and, finally, US equities represented by the rupee returns from total return indices of S&P 500 and NASDAQ-100 (INTL).
The four asset classes mentioned above are broad categories and each has sub-types; but, for simplification, we will stick to the broad categories. Each asset class has given handsome returns in the past.
Even an investment like GSEC has delivered at 8.69%pa (per annum) on median basis over the past 15 years. Gold, a part of every household in India, has beaten returns from domestic equities in the 15 years ended 31 December 2020. This is quite interesting considering that gold has no intrinsic earning power nor does it add to economic growth as companies do.
The best performing asset class was undeniably US tech stocks from NASDAQ-100, along with S&P500 which together delivered 16.60%pa in the 15 years ended December 2020. The returns from US stocks also factor in depreciation in the rupee which boosted the rupee returns. There is some benefit to investing in assets denominated in hard-currencies like the US dollar, as the long-term depreciation in the local rupee against such currencies provides extra returns.
The chart above shows how different asset classes perform at different points in time. Gold’s high returns were distributed unevenly, with large spikes in returns at certain points—mainly when there is an economic recession. Between the 10 years, gold was the worst performer of all.
Coming to the main question—how to diversify—we will construct three portfolios using the above-mentioned asset class and compare them to find out which performs better. The first portfolio is the classic equity & debt portfolio with N200 (80%) and GSEC (20%). The second portfolio is the diversified one with N200 (50%), GSEC (20%), INTL (20%) and GOLD (10%). The third portfolio is one without gold, to test whether a portfolio can do well without the shiny metal. The allocation in the third portfolio is N200 (60%), GSEC (20%) and INTL (20%). Do note that there is no re-balancing and any allocation is done only during the initial investment stage.
To interpret the above chart, let us first compare the equity + debt portfolio against the diversified portfolio. Clearly, the diversified portfolio has stayed above the equity + debt for most of the 5-year period. This shows that a simple equity + debt portfolio is not as good as one assumes.
Now let us compare the diversified portfolio with the other diversified portfolio without gold. This was done to find out whether the absence of gold in the portfolio can have major effects on returns or not. The answer is no. As the chart above shows, both types of diversified portfolio move in sync, despite one of them not holding gold.
The conclusion is that a portfolio of domestic equities, fixed-income instruments and international equity (mainly US stocks) has given the best returns with a lower downside risk.