Diversification of investments is often understood as a way to benefit from growth in various asset classes which could come at different points of time. But whats equally important is it helps manage the ups and downs of financial markets if done right. Essentially, diversification is nothing but a risk-return trade-off!
Diversification means different things to different people. Thus, what is important is to identify a good portfolio design along with timelines while execution can evolve over a period of time as one moves forward in personal and professional lives.
The broad classification that comes to mind are equity, fixed income, real estate, gold and cash. Each of these components are serve different but complimentary purposes in the portfolio – equity offer growth, fixed income provide stability, real-estate primarily for more fundamental housing need and to guard against inflation, gold as a hedge against currency risk and primarily a buy and forget asset, cash to help tide over contingencies without having to take knee jerk portfolio decisions. Its in the last bucket of cash and contingency that I would also like to put insurance – must haves of vehicle (I still seek zero depreciation even in the 8th year of my car), comprehensive family health insurance (irrespective of company provided plans) and term life insurance (with critical illness cover) which can go a long way in cutting down the contingency corpus.
While the focus on real assets (such as real estate, gold etc) can vary according to the age, profession, upbringing / external ecosystem and risk appetite of individuals, the most important areas for majority of working class are equity and fixed income. Unless you hit jackpot at a casino, race-course or KBC, these two avenues are ultimate means of funding the real assets as well – remember the down payment and pre-payment for home loans.
Thus, one should try to get these right both in terms of allocation of investible surplus and adequate diversification between these two classes. We have often come across an age based thumb rule for equity which suggests equity proportion should be 100 less the age, I have broadly been following this though with a caveat of working with broader age range. Typically 30% allocation between equity and fixed income till about early 30’s, then gradually increased the allocation towards fixed income over the next 5 years to be close to about 40% of investments in fixed income by the time our household hits 40! When I talk about mix, this is based on our investments and not portfolio value wherein those proportions could differ as equity grows faster – isn’t it how its meant to be as well.
The increasing allocation in fixed income has not come by way of higher MF investments or fixed deposits but through a long-range, and tax efficient route such as PPF contributions (besides EPF contributions), SSY scheme (feel fortunate and blessed to have this available to us) and most importantly through an Hindu Undivided Family (HUF) which holds FMPs, Tax Free Bonds, FDs but in a separate legal entity. I will cover in depth about how we intend to make our investments a bit more tax efficient through the mechanism of HUF in upcoming posts.
As far as equity goes, given compliance restrictions from office at most part, have kept away from direct equity exposure and followed the mutual funds route. The few broad principles we tend to follow are:
- Avoid commissions to the extent possible – investing through direct funds ever since they came into rouge.
- Index funds give decent exposure at fairly low cost in terms of expense ratio – have kept them little broad based as umpteen number of sectoral indexes could give way to such sectoral index funds too and restrict the diversification.
- Look for decent AUM, longer fund performance and no harm in having a multi-cap funds as large caps typically covered by Index Funds too.
- An important and often missed aspect is having diversification across different geographies thus some exposure to international equity through Fund of Funds or other mutual fund schemes which hold foreign equity (holdings converted to domestic currency), or international ETFs held through international trading account (own dollar asset, though tax return gets cumbersome but take solace that its once a year pain).
- Last but definitely not least is to start early and maintain good discipline rather than knee jerk or one shot investments.
These are some of the key pointers that have worked for me and am currently focusing more on having a bit international diversification on equity side and minimizing credit risk on the debt side.
Disclosure: I am not a SEBI Registered advisor and these are my thoughts and learning from own experience.