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How many assets do you need to diversify?

The answer is not a numeric value. It, rather, depends on your investment goals and time horizon.

In current times when many are sceptical about adding too much of highly valued equity assets and at the same time unwilling to allocate higher amounts in low yielding fixed return assets, the merits of diversification are what come to mind. 

Those who have experienced market cycles will know that no one asset or within that, no one theme can consistently outperform at all times. 

Intuitively too, you will realize that there are years when you get a high return on your fixed deposits and then there are years you don’t. Gold does well sometimes and not so much at other times. Unfortunately, it’s nearly impossible to predict when one asset or a theme with it is going to do well and that’s why we fall upon asset allocation for diversification. 

In simple terms, you have to spread out your investment portfolio in more than one type of asset in order to benefit from the up and down movement in asset prices over long-term periods. 

The question then arises, how many assets do you need to diversify adequately?

The answer is not a numeric value. It, rather, depends on your investment goals and time horizon. 

If your goals are skewed towards wealth creation, you will automatically have a higher allocation to assets which can help you achieve that and if it is regular income you seek, then fixed return generating assets is what you will look for. 

Linking asset choices to an outcome 

Primarily, there are two reasons to invest; for regular income and for wealth creation. Hence, while looking at creating an investment portfolio, include assets which can achieve either of the two goals.

If your goals are skewed towards wealth creation, you will automatically have a higher allocation to assets which can help you achieve that and if it is regular income you seek, then fixed return generating assets is what you will look for. 

As an example, let’s assume that to achieve your regular income goal you have the choice of three different assets; fixed income, gold (sovereign bonds) and real estate. Should you take on all three? For more reasons than one, that will not work. 

Firstly, acquiring real estate for the purpose of generating regular income through rentals is a transaction that requires heavy investment and a very long-time horizon. Gold bonds too come with a long-term horizon as your money is locked in for seven years. Moreover, given the annual interest coupon of 2.75%, you would need to invest a high capital for reasonable regular income. 

That leaves you with debt or fixed income. There are a few product options here which you can diversify across depending on the amount you wish to invest, the safety, liquidity, cost and time frame. You can choose from bank and corporate deposits, debt mutual funds, small savings schemes and government bonds. 

Thus, the number of assets and even within that, products, you choose will depend on the outcome you wish to achieve. 

Diversifying with past return

If maximizing return is the only objective you seek, you may be looking to diversify for returns. Diversifying only for high return can prove to be very difficult. Including more than one type of asset in your portfolio helps balance out risk and return. When one asset falters, the other choices kick in to deliver growth. However, relying on past return it can be a dangerous way to approach diversification. 

Asset price changes in 2020 have only reinforced that we can’t know in advance which asset is going to outperform another in a given period. If you are unsure of your goal and simply want to earn a return, a better approach is to filter asset choices on the basis of risk, liquidity, flexibility and cost. 

 

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