The essence of diversification and how it helps your investment portfolio

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We know that investors should not keep all their eggs in one basket. Instead, they should ensure that the portfolio is properly diversified. The rationale behind this goes a little deeper than just keeping the eggs in different baskets. Let us scratch the surface.

We invest in various asset categories like equity, debt, gold, real estate, and commodities. The major ones, in terms of awareness and popularity, are equity and debt. The essence of diversification is that the correlation between various asset classes, be it equity, debt, gold, etc., is negative. For a given set of market conditions, different assets react differently. When the economy is buoyant, equity does better since corporate earnings are growing at a brisk pace. Bonds usually do not perform well in this phase as interest rates are moving up, and interest rates and bond prices move inversely. Gold tends to do well in periods of global uncertainty. That is when people take some money off equities and move it to the safety of the precious metal. The benefit for an investor, arising from the negative correlation of various assets, is that volatility in one market is cushioned by stability in another. This reflects well in your portfolio when assets are shifted or juggled accordingly. Note that the negative correlation mentioned above is not perfect; it is neither -1% nor -100%. But to whatever extent it is there, say -0.5% or -50%—just for the sake of a discussion, it cushions your overall portfolio volatility.

It’s hard and impractical to predict the asset that gives you the highest return. Data shows that every year, the winner varies, since the market is at the confluence of multiple variables. On one hand, the allocation in your portfolio is based on