People have become more aware of inflation, investing and the stock markets. Every new advertisement and influencer is talking about a new asset, new trading strategies, crypto, NFTs and what not.
You might have started investing during the Covid recovery and made handsome profits due to the bull run, but are you able to keep up with the new range of investments and current volatility?
With the Russia - Ukraine crisis, inflation issues, strange crypto laws and new Covid variants being reported every now and then, the markets are more volatile than ever!
It’s important to build an investment portfolio that does not tear apart in such volatility.
But before we tell you the techniques that help skim volatility, let us introduce an ever important concept…
Correlation, as you might have guessed represents the existence of a mutual connection or relationship between two or more things, or assets, in this case.
When 2 assets move in the same price direction, they are are said to have a positive correlation. Look at how the Dow Jones and Japan’s Nikkei index follow the same direction over time:
Source: St Xaviers School, Jaipur
On the other hand, when 2 assets move in opposite price directions, they are are said to have a negative correlation. Look at how the prices of Dow Jones and gold move in opposite directions:
Source: Sunshine Profits
It is ideal for a portfolio to be made of assets that are uncorrelated, or better, negatively correlated. In such a way, the assets performing well would compensate for the assets performing poorly.
Creating a basket of assets that encompasses different asset classes will ensure that it has a smoother ride at all times.
You can device your portfolio by segmenting it on different bases, but the ideal ways of portfolio diversification are:
1. Asset allocation
Probably the most sensible way to build your portfolio is to acquire assets from different classes. Every asset is based on different principles and works in its own way.
A commodity or asset that is an input to something and output for something else would cause the two things to move in opposite directions.
For example, oil prices have shot up to the moon whilst the ongoing supply chain problem. On the other hand, most stock exchanges around the world are struggling to stay bullish since energy cost is a cost to their business.
Combining negatively correlated asset classes can create magic for your portfolio.
Examples of such are:
Gold prices and stock markets
Oil prices and airline stocks
Your business and the insurance you take on it
Learn how to allocate your assets:
2. Sector allocation
Categorizing your investments based on industry is another way to diversify.
Every industry produces goods and services used in different areas of people’s lives. Each sector has its own life cycle. Recognizing which part of its cycle an industry is in will help you device the right entry and exit points. A typical cycle looks like:
Not all sectors perform at the same time. Remember how the IT sector boomed in early 2000s? Or how pharmaceutical stocks were a trend during Covid? Every sector has its time. Distributing assets across all sectors will ensure you are winning somewhere, all the time.
Pro tip: Momentum in one sector signals a possible growth in another. For example, when the government announced reduction in stamp duty registrations for properties in Maharashtra, housing demand picked up. One can predict that demand for paints, tiles, etc. will also shoot up since people will be buying and decorating their homes. Read more about how it happened:
Avoid too many sectors that are positively correlated with one another to ensure a more stable portfolio.
3. Geographic allocation
Like industry life cycles, every country is at a different stage of economic development. Factors influencing the economic progress of a country are level of liberalization, resources, education system, population, etc.
In general, developed countries have more efficient markets offering more stable dividends. On the other hand, emerging countries are those that are on the verge of development and offer the fastest returns in terms of growth. Countries also differ in resources like fertile land and oil.
A mix of stocks from different types of markets can provide stability even if your home country is not doing well.
That being said, we do not live in a closed economy. i.e. countries trade goods, resources and people with one another and this influences their purchasing power and market prices. The more open the trade, more is the correlation and less are the benefits of diversification.
Learn how the crisis in Ukraine is affecting your money’s worth:
Needless to mention that correlation drastically increases when the economy enters a recessionary phase - across assets, industries and countries.
Volatility in the markets aren’t so bad. You can, in fact, exploit opportunities to your advantage. Diversifying your assets the right way can help manage portfolio volatility over time.