The biggest financial lesson from the COVID-19 crisis ... always diversify

The biggest financial lesson from the COVID-19 crisis: ‘always diversify’

By investing in more than one asset category, you'll reduce the risk of losing
money and your portfolio's overall investment returns will have a smoother ride.

Yes, 2020 has been a treacherous year, so far, for most investment portfolios. And yes, external factors that were beyond your control are mainly to blame.

But, what if we were to tell you that there was something you could have done better too. Don't fret. They say it's okay to make mistakes as long as you learn from them.

And turns out that the biggest financial lesson from the current crisis is also the simplest: always diversify your investments.

 

Here's why.

 

If you had an all-equity portfolio worth Rs 1,00,000 at the start of 2020, you're probably down a painful 28 percent to Rs 72,000 as of March-end, which means you'll need a whopping 39 percent gain to recover from the recent carnage.

And based on how unpredictable and bearish things are at the moment, you'd agree that those kinds of spectacular gains are far out in the future.

On the flip side, if your portfolio at the start of 2020 was divided between equities, debt and gold in 40:40:20 ratio, the current value would be 92k, requiring a much lower 8.7 percent gain to be whole again.

Pretty good, right? (Here, equity represents Sensex returns, debt represents 10-year G-sec return, gold represents domestic gold spot price returns as on March 31, 2020).

So, how exactly does this diversification work?

Let's take a day-to- day example. Have you ever noticed that street vendors often sell seemingly unrelated products-- umbrellas and sunglasses? Initially, that may seem odd. After all, when will someone buy both the items at the same time?

Probably never--and that's the point. Vendors know that when it rains, it's easier to sell umbrellas but harder to sell sunglasses and when it's sunny, the reverse is true.

By selling both items- in other words, by diversifying the product line--the vendor can reduce the risk of losing money on any given day. If that makes sense, you've got a great start on understanding asset allocation and diversification.

Unfortunately, unlike the vendor, who knows that monsoons follow summer and summer follows monsoons, investors don't deal with predictable economic cycles.

Economies go through ups and downs and these more often than not are unforeseeable.

Assets in our portfolio, due to their differing risk and return characteristics, respond differently to these ups and downs. You'd agree that equities run-up when the economy is doing well and gold tends to shine when the economy is down.

In essence, because it is difficult to predict the future of the economy, it is also difficult to determine the best-performing asset class. That's where asset allocation and diversification come in handy.

Asset allocation is a time-tested approach to portfolio management. It means spreading your investments among multiple asset classes such as stocks and bonds.

By including asset categories with investment returns that move up and down differently under different market conditions within a portfolio, an investor can limit significant losses.

Market conditions that cause one asset category to do well, often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk of losing money and your portfolio's overall investment returns will have a smoother ride.

If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better returns in another asset category.

The concluding point is that diversification, whilst offering no guarantees of portfolio performance or complete protection against risk, increases the possibility of an investor's portfolio withstanding the elements in a financial atmosphere experiencing both man-made and natural disasters on an almost daily basis.

Happy Investing