What exactly is the diversification and holy grail of investment? How to achieve it with correlation?
Risk and return form the major two scales in investment decision making. The higher a risk an investor assumes, the greater return he demands and hopes to get. They have a direct relationship. If an investor wants higher returns, he will have to take more risky investment positions and expose himself to potential losses. Could we somehow manage risk to increase the returns without taking the same levels of risk? This is where diversification comes in.
Diversification is an often-used buzzword in the investment world. But what does it mean? Imagine a basketball team with five-point guards. It would be an excellent lineup for freezing the ball to run out the clock at the end of a game, but it wouldn’t work for a whole game, much less a full season. Who would defend under the basket? Who would get rebounds? Or picture a baseball team with nine pitchers.
There’d be plenty of relief to face different kinds of batters, yet no manager would put nine pitchers on the field. With such notoriously poor hitters, the team would probably never score a run, so all that great pitching would still be a losing strategy. Every sports fan knows that you need a diversity of skills to win.
What exactly is diversification?
What does diversification mean for investors? The sports analogy isn’t so silly after all. Many people think that they are diversified simply if they own many different stocks or different mutual funds. However, if all the stocks are technology companies, you aren’t diversified just because you own a bunch of them. Even owning shares of a dozen mutual funds doesn’t necessarily mean diversification – not if they are all large-cap growth funds.
Raymond Thomas Dalio (pen name: Ray Dalio), an American billionaire hedge fund manager, introduced the concept of diversification as the “Holy Grail” of investment. In his book, he talks about how negatively correlated stocks can help you reduce the risk and thus increase return relative to a risk level. Let us try and understand this concept through an example.
In the above graph, Y-axis represents the risk measure or standard deviation of corresponding assets. The X-axis is the number of investment assets invested. In statistics, correlation is the linear relationship between two measurable quantities.
So, imagine if you have an asset that yields a 10% return at a risk of 10%. Adding additional investments with a 60% correlation to the other assets in the portfolio would reduce the risk from 10% to 8% when you invest in 5 assets. Similarly, if you add stocks with even lesser correlation to each other, say 10% correlation, then you can reduce your risk to half while keeping your expected returns at the same level.
What Ray Dalio found while experimenting? The answer is- the ability to reduce risk by increasing the number of investments is as low as higher the correlation between assets in the portfolio. This means is, if you take a group of investments that are 60% correlated, there is no real reduction in risk after adding more than 4 assets to the portfolio. It’s only by diversifying your portfolio that you can cut your risk. And that’s why Dalio called diversification the holy grail of investment.
How you can take benefit of diversification to minimize risk in your Portfolios
Portfolio Management as a field aims to achieve minimum risk for maximum returns- reducing the risk of the overall portfolio and maximizing average portfolio returns. Many statistical tools and ratios are used to evaluate the optimum portfolio for investors. Asset Managers and fund managers use correlation and Beta of stocks to arrive at an optimum return to risk ratio. The higher the return to risk ratio, the better it is.
Investing in correlated assets or a select few asset classes is not beneficial and exposes you to a larger risk than you would be exposed to if you have a diversified portfolio.
Invest in companies in different sectors, invest in equity, and safer instruments such as debentures that offer you regular coupon rates or annuity plans that give a fixed payment after a period. Invest in tax saver mutual funds and high-risk penny stocks that seem to have good financials and a potential sector for the future. Invest in blue-chip stocks such as Reliance or Infosys as well. Pickup stocks in renewable energy companies like Tata Power and in Tech companies such as Tech Mahindra and Wipro.
Ultimately, the stocks you pick will depend on each person’s risk-taking capability and their expected return. So, before picking stocks, evaluate what you are expecting from your investments.
Calculate the level of risk you want to be exposed to. Risk-averse people can reduce losses with Stop-loss functionality through brokerage software offered by banks and other brokerage houses. I personally find Zerodha’s Kite mobile application fast and with minimum lags in placing orders. You can easily apply for IPOs through the app as well. Opening an account is easy, and KYC procedures barely take a few days.