Diversification In Investments: Here’s How To Mitigate Risks During Volatile Markets

Markets across the world, and India in particular, have been volatile in the recent past. After a steady bullish trend since Apr ’20, the markets were flat between Oct 21 – Jan ’22. Rising tensions between Russia and Ukraine have started affecting oil prices. As oil prices started rising, inflation started rising. This affected the stock markets and the Nifty started trending downwards. Oil prices, and consequently inflation, remained high even as the Russian invasion of Ukraine began in February 22.

In April 22, inflation hit an eight-year high of 7.79%, much to the consternation of the markets. Between Jan ’22 and Mid – Jun ’22, smelly Dropped ~12%. The war affected supply chains around the world, increasing the prices of commodities such as wheat and oil, and resulted in persistently high inflation around the world.

To deal with this, RBI is increasing the repo rate from 22 April. The central bank has so far raised repo rates by 190 bps (1 bps 0.01%) to 5.9%. RBI still to 35 50 bps rate hike To manage inflation within the mandated band of 2-6%. As a result of these factors, there has been a downward trend in global growth.

The International Monetary Fund predicts that global growth will slow to 2.7% in 2023, down 0.2% from its July forecast. India is expected to grow at 6.8% in 2023, much lower than the 8.7% recorded in 2022. The 2023 growth rate for India has been revised downward by 0.6 percentage points relative to the IMF’s June 2022 forecast. Inflation is also expected to remain elevated in the near term. All these factors are expected to impact the stock markets, which may lead to volatility in the near to medium term.

Below are some common mistakes investors make in volatile markets:

Panic Selling: When the market declines, investors often make the mistake of exiting equities at a lower price. This is because investors are generally loss averse. They prefer to avoid losses to obtain equivalent gains. What they fail to understand is that emotions drive the stock market in shorter time frames. Fundamentals always drive the stock market over the long term. The best thing to do is to stay invested until the rationale for investing changes.

Trying to time the market: Once investors sell low in panic, they make the mistake of trying to time the market and buy when market conditions improve. This results in short selling and high buying.

Living in Cash: We all love those big sales and our favorite brands at discounted prices, except when it happens in the stock market. Investors fear short-term volatility and avoid investing money they would have otherwise invested.

The consequences of these mistakes can be dire, especially for novice investors. It is common knowledge that the long-term performance of investors in the stock market is directly related to the success of their first investment. If the investor faces losses in the early days of his equity investment, he gets demoralized. Due to loss/underperformance and not making an effort to understand the risk associated with equity investment, the investor quits investing in equity instruments.

For example, investing in equity after watching influencer videos is a recent phenomenon. Investors confuse discussions about highly volatile stocks as recommendations, buying the same, without understanding the associated risk. They then get disheartened when the stock price falls.

The simplest way to reduce or avoid the high risk associated with investing in a single stock or group of 1-2 stocks is by adopting a diversified portfolio investment approach. It involves combining a wide range of instruments and investment styles to reduce portfolio risk. Commonly used instruments are equities, bonds, commodities such as gold and even real estate.

Investment style involves selecting various sub-asset classes within an asset class to reduce portfolio volatility. For example, investing in value stocks along with growth stocks, buying large-cap companies as well as mid-cap companies etc.

One way to construct such a portfolio is by following a core-satellite approach. This approach involves dividing the portfolio construction process into 2 parts:

core part

Preferably, the core portfolio should provide exposure to diversified asset classes such as equity, gold, debt etc.

The core portfolio should only consist of passively managed assets. This ensures that the core generates returns in line with the broad market returns. Additional benefits of passively managed assets are lower expense ratios, lower transaction costs, and tax efficiency.

Investors can build a strong core by using ETFs and REITs. ETFs such as Nifty Bees and Gold Bees provide exposure to large-cap equities and gold respectively. Bharat Bond ETFs provide exposure to debt. Real Estate Investment Trust (REIT) There are companies that own and operate income-generating real estate. There are currently 3 listed REITs in India.

A smartly constructed core provides stable long-term returns and ensures that the foundation of your portfolio is strong, protected and grows.

satellite part

In the satellite portion, investors must invest in actively managed funds or invest directly in a group of stocks. The goal is to select investments that are likely to outperform the broad market either through market timing or stock selection. This aspect of the portfolio will incur higher transaction costs due to higher portfolio churn. Most fund managers cannot consistently beat the index. Hence investors need to study the performance of the funds/managers from time to time and change them if required.

Core-Satellite is a common-sense portfolio-building approach that provides access to the best of both active and passive investing. While the Core Fund has low costs and limited volatility, Satellites provide the potential for outperformance.

Like old age, the ups and downs of the market are also a fact of life. While one cannot take it away, following a common sense investing approach and avoiding basic investing mistakes will ensure that investors beat the market in the long run.

Naveen Kaushik Ranjan, Smallcase Manager & AVP, Investment Products, windmill capital