While we talk, imagine treating yourself with a ‘Bahubali Thali’, on a lighter note let’s assume it’s the veg thali.
This thali comprises a minimum of 30 delicacies all up for you to grab.
From which segment of delicacies would you start first?
Would it be starters, appetizers, beverages, curries with rice and rotis?
Overwhelming right?
One thing is for sure, considering, even if you choose beverages as the last part to taste you will still make it a point to taste it after making sure you finish your favourite part.
Let me help you draw parallels with ‘Bahubali Thali’ and ‘Finance world’.
The popular delicacies among the investor community for assert classes are stocks, mutual funds, fixed deposits, bonds, real estate, gold etc.
All of us would like to watch our money grow. Therefore, we invest in as many Asset classes as possible.
I’m sure you’ll agree with me?
But why all of them and not a particular one?
Because we want to spread our capital across different asset classes to reduce the overall investment risk.
Diversification ensures that by not “putting all your eggs in one basket,” you will not be creating an unwanted risk to your capital.
Let’s consider a scenario – A student who is about to start his under-graduation course. He decides to opt for dual specialization in –Electronics and Electrical Engineering.
He believes that by graduating with two specializations he can reduce the risk of not being placed in a job.
Also, specializing with good knowledge in both the main systems will have an edge.
This young man completes his Engineering (dual specialization) and gets placed in an Electronics hardware manufacturing company.
He decides to start investing for his long-term financial goals in both Equity, Debt & Gold Asset Classes in the ratio of 50:30:20.
He invests 50% of his investible surplus in Equity Mutual Funds, 30% allocation goes to EPF+PPF and the remaining 20% in Gold ETFs.
He believes that investing in a well-diversified portfolio with uncorrelated Asset classes can mitigate the risk.
He aims to achieve decent inflation-adjusted positive returns but with a lower level of risk.
Here comes my next question,
What does he mean by ‘uncorrelated asset classes’?
From an investment angle, correlation indicates how one Security or Asset class moves relative to another, either up or down.
Perfectly correlated asset classes have a correlation of 100% or +1.
Uncorrelated is exactly the opposite of the above.
When the value of securities or Asset classes moves in opposite directions, they are negatively correlated having a negative correlation of 100% or -1.
So, when two assets move in the same direction together, they are considered to be highly correlated.
When these asset classes move in the opposite direction, they would be negatively correlated.
Many a time, we notice that dollar and oil prices tend to move in ‘opposite’ direction i.e., these two asset classes are negatively correlated.
Importance of such type of investment portfolio
Portfolio diversification in straightforward terms is achieved by investing in different asset classes.
But, ‘how these Assets are related’ should also be given more importance.
Adding negatively correlated assets to your portfolio can reduce the risk considerably.
The best asset portfolio is an outcome of comes combining negatively correlated assets.
It is observed that Equity and Gold are negatively correlated assets and Equities and Bonds are negatively correlated assets.
Below are some highlights which cannot be neglected while building a Portfolio which is Diversified with non-correlated assets.
Now that we understand un-correlated, there is low correlation and high correlation.
With the help of these two subordinate terms, we can strategise our portfolio more effectively.
Low Correlated asserts assist in reducing the volatility of your investment portfolio without necessarily affecting the expected level of return.
But, it does not take away the ‘RISK‘. Your investments are still subject to various risks.
It is next to impossible to identify ‘perfectly‘ uncorrelated Asset classes.
Since we are also dealing with the associated risk factors here, considering longer periods to understand the correlation of Asset Classes gives an upper edge.
Note that a portfolio with negatively correlated assets can’t guarantee higher returns.
The key point od adding negatively correlated assets is, the highs won’t be as high, but the lows won’t be as low, which can lead to a more consistent risk-adjusted return.
Also, being on the uncorrelated side alone is NOT enough.
It is very important that the stocks or asset in question has an expectation for POSITIVE returns in the long term.
The concept ‘uncorrelation’ can also and should also be applied within the same asset class.
Diversification among asset classes is good, but that does not necessarily mean to venture into investment avenues that you do not understand and are highly speculative in nature.
The percentage-wise of Asset allocation also matters a lot when constructing your investment portfolio.
Investors need to review their portfolio and try to re-balance it whenever it is required.
The most important keynote is that correlation can change.
The relationship between two Asset classes can change due to various economic factors, natural or artificial calamities, election results, reforms and schemes.
Despite investments becoming more highly correlated, smart diversification can still reduce the risk and increase the return of your investment portfolio.
With unpredictive futures, the various Asset classes still tend to perform differently and well in times of crisis also, and the gains of one can fill the losses another.
So, you need to find understand your risk appetite, then if needed consider professional aid to find a mix of investments that suits your risk tolerance and long-term investment goals.
Happy Investing!
Until next time…