Why You Should Diversify Your Portfolio Across Asset Classes

Jan 31, 2022 03:21 PM ET
Why You Should Diversify Your Portfolio Across Asset Classes

In 1952, Economist Harry Markowitz laid down a concept called the “Modern Portfolio Theory” (MPT) in an essay. The theory laid out a mathematical framework that helped assemble a portfolio of assets. This portfolio theoretically was such that it offered the highest expected returns for a given level of risk. Markowitz went on to win the Nobel Prize in economics for this work. The most critical component of MPT was the concept of diversification.

In the simplest terms, diversification is the mathematical manifestation of the age-old saying, “Don’t put all your eggs in one basket.” It is common to see any stock market investor holding a portfolio of stocks. The investor would typically have 10 to 30 stocks in the portfolio, at times even more. While this usually reflects the view of the investor on each of these stocks, it also provides the benefit of lower risk. 

For example, the investor could have easily chosen to invest all the money in just the five most high conviction stocks. Yet, they choose to go for a large number of stocks. This is because it is unlikely that all the 10 to 30 stocks in the portfolio would fall together.

This same concept of diversification should ideally be expanded across all asset classes and should not just be limited to the stock portfolio. With new technology, products, and financial literacy, it is possible for a retail investor to invest in almost every asset that is available to large institutions and hedge funds.

Age-old financial wisdom suggests having a portfolio of 60% equity and 40% debt which is also colloquially known as the 60-40 rules. But over the past few years, several investment opportunities have opened up, both old and new.

Technology has opened up new investment avenues

The launch of ETFs, particularly ETFs tracking commodities, like gold and REITs, which offer fractional ownership in real estate, has opened up many other investment options for retail investors. To own real estate, earlier, investors had to physically own a house which would cost thousands of dollars, as well as quite a bit of paperwork. So the investment required a sizable sum of money and was time-consuming as well. 

But now, one can own real estate via REITs (Real Estate Investment Trusts) as easily as one owns stocks. For gold as well, one doesn’t need to buy gold jewelry or coins but can simply buy a gold ETF which is available for just $30 a unit. Additionally, you can benefit from market indices and sectors and earn dividends by investing in ETFs. Finally, the appearance of cryptocurrencies has created an entirely new asset class, and there are, of course, multiple simple ways to invest in these.

What’s more interesting is that several of these asset classes are uncorrelated or at times negatively correlated. This is noticeable in debt investments such as treasuries and safe-haven assets such as gold.

Significance of asset correlation and impact on returns

The early part of the year 2020 was especially an eye-opener on what happens when one doesn’t diversify across asset classes. In 2019, US equities were among the best performing asset classes, so investors would have piled on equities in their portfolios naturally.

Significance of asset correlation and impact on returns

However, as the pandemic unraveled, equities corrected by as much as 20% in a matter of weeks! At the same time, gold prices touched record high levels given gold’s safe-haven status.

Significance of asset correlation and impact on returns

On top of that, a stock market crash of such an extent provides a great buying opportunity. Nut people who would have concentrated their funds in equity wouldn’t have been left with any money to invest. On the other hand, investors who had made some allocation to gold saw its value increase.

As a result, they could liquidate their investment in gold and then go on to invest in equities that were available at record low prices. As we know now, several stocks have doubled over the past year offering stellar returns. So a simple diversification would have allowed the investors to participate in a once-in-a-lifetime stock buying opportunity.

How to accommodate new asset classes such as crypto in your portfolio?

Above we discussed asset classes that have been existing for the past several decades. Even though the investment avenues for retail investors have opened up only recently, the data of their price movements and returns are available extensively. As a result, their returns are more predictable, and their correlations are strictly defined.

Over the past decade, though, cryptocurrencies have emerged as a new asset class. Even though initially they were shrugged off as simply speculative tokens, today, even large institutions like JP Morgan and Goldman Sachs have set up cryptocurrency trading desks.

What’s more intriguing about the cryptocurrencies is that, unlike the other asset classes, it was the retail investor who first decided to invest in these. As a result, there are already several existing platforms that allow us to buy these tokens in a matter of minutes with a few clicks. But since cryptos have a short history that has been rather volatile, it is difficult to ascertain their future price movements and returns.

While many crypto proponents argue that cryptos are stores of value like gold, their price movements reflect otherwise. Ideally, cryptos should have gained in a stock market cycle. Still, during the early weeks of the 2020 crash, cryptos also fell, indicating that they are not completely uncorrelated to other asset classes. Hence it is important to have cryptocurrency in your portfolio, but its allocation should not be very large as it can dictate the returns of the entire portfolio.

Rule of thumb suggests that no asset class should hold more than 40% of the weight in the portfolio. Additionally, one must periodically balance the portfolio to adjust the weights. Any investor who does this will create a large amount of wealth over the long term consistently.

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