The fallacy of portfolio diversification

Not putting all eggs in one basket is perhaps one of the oldest risk management techniques. In the financial investment parlance, this is commonly called “diversification of portfolio”. Over the years this technique has worked well for investors in managing risk.

In earlier times, diversification was a rather simple exercise. This usually involved allocating money to asset categories (equity, debt, commodity, real estate, etc.) that carried divergent risk profiles. During low inflation, easy money periods equities and real estate outperformed the debt; while in high inflation tighter money periods, bonds and commodities did better.

However, as the markets became more globalized, financialized, and dematerialized, the performance of various asset classes started to become more correlated. With more and more assets offering a similar risk profile diversification of portfolios started becoming a complex and complicated exercise.

In the past decade, we have seen sovereign bonds carrying more risk than equities; multiple geographies carrying the same risks; gold and silver not providing any hedge against monetary debasement; and bonds worth trillions of USD carrying a negative yield while the major central banks were printing unprecedented money.

In an attempt to resolve the complexity in diversification, further complications were added in the form of Art, Diamond, Luxury Yacht, digital token (NFT) and cryptocurrencies etc. Many of these lacked objective value parameters. Some of these were even depreciating assets. Some others did not have explicit legal sanction to trade freely.

In the past three years in particular, diversification tools like geographical diversification, debt-equity diversification, growth-value diversification, emerging-developed diversification; sovereign-private bond diversification; etc. did not always provide the desired results for the investors.

The reason is simple. Most assets, geographies, and economies have become much more correlated to each other. For diversification, it is critical that the assets in the portfolio are mostly uncorrelated. If the assets are reacting (or not reacting or that matter) in the same manner to a macroeconomic or geopolitical occurrence, their risk and return profile cannot be expected to be much different.

My recent interactions with multiple investors, money managers, and advisors indicate that the understanding of the concept of diversification as a risk management tool in Indian markets may be extremely poor. In the name of diversification, investors are being lured to invest in bonds that are riskier than equity; multiple mutual fund schemes holding a similar basket of stocks; and gold that has mostly been a currency and import duty hedge rather than inflation, interest rate or market risk (see here).

In the name of diversification, investors are many a time sold a variety of mutual fund schemes which not only are similar in risk profile, and sectoral exposure but contain the same securities.

To make my point clear, I would like to highlight the case of an investor XYZ. This investor claims to be very conservative with moderate return expectations. The advisors told him to have a “simple” and well-diversified portfolio. Out of Rs350, he was advised to invest Rs100 each in a Nifty50 ETF, BankNifty ETF and Nifty500 ETF and keep Rs50 cash for direct equity opportunities to optimize overall returns. This Rs50 was recently invested in HDFC Bank stock (considering it to be very safe and promising in terms of return.)

On the face of it, this appears a simple, safe, well-diversified portfolio. But a simple analysis would tell you that this is perhaps one of the riskiest portfolios one can construct under the current circumstances. This investor has effectively invested ~61% of his money in financial sector stocks, and worst, ~29% in just one stock, i.e., HDFC Bank. Regardless of the attractive valuation, recent underperformance, future prospects of a company, no risk manager can justify this type of asset allocation for a conservative investor with moderate return expectations.

(Note: HDFC Bank has a weightage of 13.5% in Nifty50; 29.4% in Bank Nifty and ~8.4% in Nifty500)