The Final Frontier by Navneet Munot, CFA

It is almost that time of the year. A time when the ‘I’ in India has company from ‘I’ of ‘Independence Day’, with no mention of India being complete without a mention of its Independence Day and more recently, of the first year of India’s journey in Amrit Kaal. Over the last few years, they have been accompanied by the ‘I’s of Infrastructure (physical, social and digital), Investments (public and private) and Investors (domestic and foreign). India’s elevated focus on infrastructure has grabbed a lot of attention, and rightly so. A synergy of long-term vision and speedy execution has not just caught the eye of masses in India but has also been noticed globally, by investors and policymakers alike. More importantly, what makes India’s infrastructure push unique is its focus on People, Planet and Prosperity.

Diversification: The Concrete of Personal Finance

While infrastructure is the backbone of any economy, it would be fair to say that the backbone of physical infrastructure is concrete. As surprising as it may sound, concrete supposedly is the second most used substance in the world – second only to water. Interestingly, concrete is a combination. A mixture of cement, sand, gravel and water in specific proportion. None of these constituents in isolation can give construction the strength that it needs. More importantly, even an incorrect proportion can weaken the concrete. Something similar happens in the world of investments. One of the most important decisions in investing deals with getting ‘the combination’ right. Simply put, having the right diversification across asset classes is more important than anything else.

Markowitz and Portfolio diversification

While the tenet of diversification has been harped on enough nowadays, that wasn’t always the case. The world of investing owes it to a number of economists, including Harry Markowitz, a Nobel laureate, who passed away in June this year. Over the years, they gave a sound theoretical framework to portfolio construction which continues to find application across the world of investing today.

Bang for the buck

Historically, investing revolved around individual stocks and their NPV (Net Present value). Future cash flows of securities were discounted to find the NPV of securities and the ones which yielded higher NPV were selected, without paying heed to how they in combination would perform within the portfolio. Markowitz stated that it is not enough to look at absolute returns of securities in isolation. Instead, his Modern Portfolio Theory (MPT) and Efficient frontier put forth that investors should look to maximize risk-adjusted returns, with the idea being to maximize return for a given level of expected risk or to minimize risk for a given level of expected return. Such an efficient portfolio could be achieved by diversifying across securities with low/negative correlation. This theory quashed the notion that merely adding securities equates to diversification. The underlying emphasis was on correlation between the securities and diversifying across securities with low/negative correlation.

Tenet of diversification lives on

Over the past few months, quite a few investors, being wary of equity valuations, stayed on the sidelines, expecting an impending correction. However, the rally in equities continued unabated without taking a breather. Episode like this shows how investors often make the mistake of trying to time the market and asset class cycles, when it is quite difficult for them to do so. The best way to avoid this predicament is to have a strategic diversification across asset classes, and within equities, across market-cap segments and sectors. Trying to change lanes, with a rear-view mirror, has historically turned out to be a costly exercise.

Volatility – A friend or a foe?

Modern Portfolio Theory dealt with the trade-off between risk and return, with volatility of returns being considered the measure of risk – ignoring the fact that for a long-term investor short term fluctuation in security prices may be quite irrelevant. Intuitively, the possibility of losing capital invested should have been considered the risk. In fact, for true long-term investors, short-term volatility can be a friend, provided investors stay disciplined and invest regularly, irrespective of ups and downs in the market. Systematic investments (SIPs, STPs) in Mutual Funds can help investors get over any fear of short-term volatility and more importantly, make the most of it through Rupee Cost Averaging (by buying more units at lower price and vice versa). 

Asset Allocation is the key, Hybrid Mutual Funds make it easy

Even if investors pay heed to the tenet of diversification, getting portfolio diversification right, as per one’s financial journey, is easier said than done. That’s where a wide array of Hybrid Mutual Fund schemes like Balanced Advantage Funds, Aggressive Hybrid Funds, Multi-Asset Funds, Asset Allocator Fund of Funds etc. can make things easier for investors. These schemes offer diversification not only across asset classes but also across sectors and market cap segments within equities – not to mention the professional expertise in security selection that these products bring to the table. It would be fair to say that in the world of personal finance, Mutual Funds not only create the concrete but also help build the road to financial freedom in the long-term.

Of diversification, diversity and synergy

Diverse range of asset classes, sectors, market cap segments etc. can make one’s financial journey a fulfilling one. In a similar vein, diverse mix of languages, dialects, customs, cuisines, culture, weather, topography etc. make India a vibrant nation like none other; and which in many aspects is more diverse than a continent. This unity in diversity makes India’s focus on inclusive growth even more laudable as the endeavour is to move forward cohesively on the path of economic development. Unlike Markowitz’s Portfolio Theory and Efficient Frontier, which prefer individual constituents with low/negative correlation, India’s diversity needs all its stakeholders to move together in sync, as we stride towards the final frontier of transitioning from an emerging economy to a developed one in Amrit Kaal.

*The article was originally published at https://www.hdfcfund.com/insights/md-ceo-desk/final-frontier 

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”