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Diversification | Eggs, Baskets and All That

Updated: Feb 22, 2022

'Don't put your eggs in one basket' is the most common proverb ever when it comes to diversification. And we're using it too! Rather self-explanatory, but here it is - you put them all in one basket, and then the basket falls, and you lose all your eggs. So instead, you just put them in different baskets, so you distribute your risk, and still yield well on your overall portfolio.

Diversification in investing

From an investment perspective, this implies placing your money across asset classes or instruments. With different asset classes, the idea is to reduce the amount of correlation (the amount two things move together) in the portfolio, thereby reducing volatility.

With different instruments in the same asset class, say equity, a larger number of stocks would result in a cancelling out of company-specific risk with one another, till all that the portfolio is exposed to is the market risk. Basically, when one company goes through a troubled time, the others don't.

It's all a trade-off

Diversification is all about trade-offs. It reduces exposure to singularity for investors. While that reduces volatility (and the risk of a bad outcome) on the overall portfolio, it can also cut into the investor's return potential.

For example, say:

A 100% equity portfolio has an annualised return of 15% and standard deviation of 20%, and

A 100% debt portfolio has an annualised return of 8% and standard deviation of 5%, then

A 50% equity and 50% debt portfolio will have an annualised return 12% and standard deviation of 11%.

Now while the standard deviation is materially lower, so is the return. See - trade off! This helps you

Rupeeting Core Portfolios

One of the key tenets of our investment philosophy is that of diversification. We are of the opinion that core portfolios and investments should be well-diversified, to weather investors from storms in one particular market.

Rupeeting Core Portfolios use diversification across 5 asset classes. We try and reduce the risk to portfolios by adding uncorrelated assets, that also have great potential to earn returns. That's how we land up with asset classes like international stocks and gold, and not just stick to naive diversification between equity and debt.

To ensure returns aren't compromised, we apply some heavy-duty quantitative models to ensure that two things run in parallel - risk minimisation and return maximisation. We work hard to find that sweet spot where the two equations are perfectly balanced.

Just look at the results! Look!



We want you to see a few points here:

  1. Sharpe Ratio - Despite diversification, we are able to achieve outperformance on our portfolios relative to the benchmark. We do realise that the portfolios also have a higher standard deviation. However, what we look at is the Sharpe Ratio. Wait, Sharpe Ratio? As we said earlier, in our quantitative models, we maximise for returns and minimise risk. We find that right balance to maximise the amount of return we are able to generate for the risk we take. This is visible in the Sharpe Ratio (which simply is the excess return divided by the standard deviation).

  2. Volatility - Despite the increase in standard deviation, see how the positive periods in our portfolios are more than that in Nifty100, and the negative periods are lesser. Also, notice how the swings (returns in the best and the worst month) are lesser than Nifty 100. That's the beauty of diversification!

Intelligent diversification

We are all pro diversification, and that's why it forms a critical part of our investment philosophy, and our investment decisions. But beware of naive diversification. You need to do it intelligently like we've done it in our core portfolios. Get reduced volatility, but compromise on returns as little as possible. Let an egg crack, and not break, I guess!

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