Stock Pathshala: Module IX

Hey everyone, a warm welcome to another intriguing article in our journey towards understanding equity investments.

In this article, I’m going to cover four simple points about diversification:

1. What exactly is diversification?
2. With the advent of cryptocurrencies, how should you diversify your investment portfolio?
3. Designing your portfolio
4. Key points to remember

Diversification is one of the most important rules in finance. Interestingly, this concept in finance does not take its root in finance but in literature.

Don’t put all your eggs in one basket

This proverb is used by Don Quixote and he explains —

It is the part of a wise man to keep himself today for tomorrow and not venture all his eggs in one basket.

Now, it’s used in finance, and it is one of the principal concepts that you need to understand if you want to succeed in the stock markets.

So what is the meaning of diversification, and why is diversification important?

So diversification essentially means your investments should look like a pie. It should be bifurcated into different investment classes. For example, you can have some percentage of your portfolio into equities. You will have some portfolio in debt. You should have a portfolio in real estate. You should have some portfolios in New Age instruments like cryptos.

But why is that diversification essential?

1. Dependence over multiple asset classes:

Suppose your investment kitty includes only a house you have bought to live with your family. So in this scenario hundred percent of your investment is a house; that’s it. You don’t have any other investment. Be it stock, be it gold, cryptocurrency, etc., and this can become a massive problem for you if something bad happens to this real estate or the piece of asset or investment that you are holding. This is the first key reason why your investment portfolio needs to be diversified. It needs to be bifurcated into different asset classes.

2. Hedging benefits:

You might have heard that in some years, the gold moves up, and then it stabilizes for a few years, and then it comes down. So, for example, this was a scene with the gold cycle between 2010 to 2014. But you also invested in Nifty, and it went up. So in this period, while the gold mostly stayed stable, your stock investments increased. So if you’re diversified, your particular asset A hedges asset B.

Therefore, you should diversify across asset classes, and even within the same asset, you must diversify. For example, if you’re buying stocks, don’t just buy one stock and be done with it; diversify and buy a bunch of stocks.

So, in conclusion, if you are putting all your eggs in one basket and if you are not diversifying and if that basket falls, all your eggs or the majority of your eggs will break, which is a bad situation.

Major asset classes to invest for diversification:

1. Equities:

Stocks like HUL, reliance, or equity-oriented mutual funds.

2. Debt:

Debt means that you’re investing in debt instruments. For example, some big companies and governments take loans from people; they call it bonds. So the government will issue a bond, and you as an investor will get a chance to loan out your money to the government, and the government will pay you a rate of interest.

3. Real estate:

If you are buying commercial property or buying a rental property, you are buying real estate.

4. Commodity:

Invest in commodities like oil, gold, silver.

5. Cryptocurrencies:

Bitcoin, Ethereum, and these New Age investment instruments could be NFTs as well. Here you are taking a long-term perspective on the world.

Designing your investment portfolio

Suppose you have10 lakh rupees to invest right now. To design your portfolio first, you need to ask yourself a couple of questions.

1. What is your age?
2. What is your risk appetite?

Now, if you are young, then you should invest more of your money for growth. If you are slightly older, then you should invest the majority of your money in regular withdrawals.

So if you’re looking at stable income flows. Then invest in dividend-oriented stocks because you’re getting monthly cash flows, and you can utilize that to live your life.

If you are young and can withstand the dips in the stock market, for example, in 2020, when the stock market went down and if you don’t have age on your side and some medical emergency comes up when the stock market is down, then you will have to sell your stocks at a massive loss to recoup the investment. So that becomes a bad scenario.

So generally speaking, if you’re young, you should invest in growth assets, and if you are old, you should invest in stable assets.

Now you need to superimpose this rule with is your risk appetite

For example, if you are someone who is a risky investor, then you can allocate more of your funds towards equity, cryptocurrencies, etc. If you are somewhat of a risk-free investor, you should allocate most of your money in debt funds and fixed deposits.

Now let me create 2 profiles and try to outline how you should go about designing your portfolio.

First category: Assume that you are in your 20s and you are a balanced investor. That is, neither are you too risky, and neither are you risk-averse.

Second category: Assume that people are in their late 40s or early 50s, and they too are balanced investors.

Portfolio design in Scenario 1: When you are in your 20s or 30s, essentially, you are looking to grow your wealth.

So have :

1. 60 to 70% in equities
2. 10% in debt
3. 10% in gold
4. 10% in Cryptos

Now, if the market conditions look stable or if the market is in the growth phase, the way it is right now, please keep a little debt portion in debt and invest mostly in equities. Use commodities purely for hedging. You can buy gold and silver for that. The remainder should be in growth capital like cryptos, which are the next-gen finance.

Portfolio design in scenario 2:

1. 30 to 40% in equities ( Only blue-chip companies )
2. 40 to 50% in debt ( AAA-rated bonds )
3. 10% in commodities ( gold )

If you require a regular income flow, then the majority of your money should go into debt. In terms of equity, you should only go with large, stable blue-chip companies. The idea is to reduce volatility.

That’s it, and you are good to go. So this is what I would say about developing your own investment portfolio.

Key points to keep in mind:

1. If you are a risky investor, then equity and cryptocurrencies are a great bet for you. But always hedge your risks by learning about futures and options or invest in commodities.
2. Please do not look at your house as an investment because if you get habitual to living in a house and are very happy that your house is worth five crores. It’s doubtful that you’re going to sell it and move someplace else. So please don’t consider your house, in which you are living as an investment. You buy a house for a living, so do not consider it an investment in the traditional sense.
3. If you are a risk-free investor, please invest some of your money in FD and invest the remaining in passive mutual funds. Just make monthly SIPs, and you will do well.

With this, I would like to conclude this article, hoping you have gained something insightful.

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