Mitigating portfolio risk through diversification

Last Updated on Apr 6, 2021 by Manonmayi

Risk is inherent in investments. No matter what, it cannot be avoided, but it can indeed be managed.

We are all familiar with the risk-return trade-off (higher returns can be commanded with higher risk appetite; on the flip side, safe investments might not yield you stellar returns). This brings us to a fundamental concept in finance which lies at the heart of risk management, called diversification.

Before discussing diversification and how exactly can it help you, let us first understand risk.

Table of Contents

What is risk?

Risk can broadly be defined as a deviation from the expected. We invest in any financial asset with the hope of a positive deviation. Risk is a result of an unintended outcome (say the value of the asset decreases). Even the most well-reasoned decisions are laced with risk.

Benefit of diversification

This is where diversification can help by preserving returns at a reduced risk. Essentially means that you do not want one bad event to wipe out your entire portfolio. This is why you place your bets on different asset classes and also look for variation within the selected asset choices.

Here’s an example. Just as in a cricket team, we have players with different specialities whose combined efforts are directed towards winning; imagine your portfolio doing the same for you. You want to maximise your return by diversifying. You want to build a corpus over time that caters to different needs and also mitigates adverse impacts. For example, for a fixed return, you might park your funds in a fixed deposit, create an SIP for regular monthly investments and also invest in a few stocks. This exercise is fairly intuitive and most of the people with time diversify over asset classes. But what is not apparent to the naked eye, is that you might be, let’s say, putting your money into a few stocks or stocks that belong to the same sector or buying stocks of various sectors that generally move together.

Type of risks

Before discussing why this could pose a problem, let us understand the types of risk associated with stocks. There are two types of risks inherent in stocks – systematic risk and unsystematic risk.

Unsystematic risk

Unsystematic risk is the risk which is specific to a firm and hence can be diversified. For example, a company faces some turmoil in its management, and its stock price might tank due to the same. In such a case, if all your fortune is tied up to one company’s stock and God forbid something like this were to happen, you face significant wrath. This is why diversifying becomes critical in such a scenario, so that downfall of one would not affect the capital deployed in other stocks. Hence, it is advisable to put money in different stocks and also to get exposure to various sectors.

Another example would be – that there has been a lot of discourse on how the consumer discretionary stocks, finance stocks (Banks, NBFCs, etc.) might see resistance/downfall due to the Covid-19 impact and our recovery from it. The former might slip down the spending ladder, and NPAs might hit the latter. At the same time, pharma stocks were expected to perform better as we manoeuvre out of the Covid-19 crisis. Here’s the Year-to-Date performance comparison of all the three abovementioned sectors (relevant S&P indices).

This substantiates the necessity for diversifying across sectors for equity stocks to reduce our exposure stemming for significant standalone events like these. Mutual funds inherently do this for you by parking money in different stocks and across sectors.

Systematic risk

Now coming to the second type of risk that equity stocks face is systematic risk. This risk cannot be diversified and is not specific to specific firms, for example, macroeconomic risks, political risks, etc. However, some metrics can help us understand the extent of our exposure. One such metric that measures stock sensitivity is the Beta coefficient. The Beta of a stock gives us its volatility as compared to the overall market volatility. Beta is calculated by regressing a stock’s return to the market return. Hence, the Beta provides a correlation of the stock return with the market return. A beta coefficient of greater than one would mean that it is an aggressive stock (price movements are more pronounced than the overall market) and a beta coefficient of less than one would suggest that it is a defensive stock (less reactive to the overall market). A portfolio with different betas can give varying exposure and help us balance the portfolio.

Harvard Business School Professor Mihir A. Desai succinctly describes the high, low and negative beta assets in our life in his book The Wisdom of Finance,

“So who are the high-beta, low-beta and negative beta assets in your life? The high-beta assets in your life are likely your Linked-In network or professional acquaintances. These relationships are largely instrumental; in other words, these individuals are likely to show up when you do well and disappear when things go poorly….Low-beta assets are considerably more valuable – they are the steady friends who are there for you no matter what happens to you. Infact, this classification of friendships closely mirrors the taxonomy of friendships provided by Aristotle in Nicomachean Ethics…But Aristotle reserves the highest praise for the love that is unconditional – the negative-beta assets in your life. When you stumble the hardest, these people are there for you the most – and when you fly too high, they manage to pull you back down to earth.”

How to tell if you are already diversified

If you look at your portfolio’s performance and observe that constituents have moved in different directions at times, then you might be diversified to an extent. It is worthwhile to note that gold is a very low or even, negative-beta asset which means that it moves in the opposite direction vis-à-vis the market. However, it is critical to ensure that you do not over diversify yourself, i.e. you park money in ‘n’ different assets resulting in chaos and inability to manage your portfolio.

To conclude, the risk of any investment cannot be assessed in isolation, but only in terms of how it behaves relative to a diversified portfolio. Diversification not only helps in managing risk but also provides an opportunity to preserve returns insulating us from external shocks that can wipe out the entire portfolio.

To sum it up, would like to leave you with this –

Jack of all trades, master of ~~none~~ managing risk [through diversification].