4 portfolio diversification mistakes one must avoid in 2022

Another example is data in two parts: (1) Apple increased more than 6,000 percent from 2002 to 2012 (2) Apple stock declined on 48 percent of all trading days.

Lesson: it is never a straight path up.

At Berkshire Hathaway’s 2021 annual meeting, Buffett pointed out that in one of the hottest sectors in the 20th century – automobiles, there were over 2000 defunct companies. In fact, after the 2008 meltdown, there were just three left; of which two had been rescued from bankruptcy by the US government. Hence, he went on to say – “…there was a lot more to picking stocks than figuring out what’s going to be a wonderful industry in the future.”

As per SEBI guidelines, sector focused funds invest a minimum of 80 percent of their assets in a particular sector like banking, healthcare, real estate, energy, etc. A lack of diversification means that the risk-return profile of these funds tends to be towards the riskier end. So, even if one may be particularly bullish about the prospects of a certain sector, it may be prudent to restrict allocation to such funds to under 10-20 percent of your portfolio.

Often while investing in mutual funds, PMSs, or AIFs the underlying assumption is that investing in multiple funds will lead to diversification. However, it is important to check the underlying holdings of the funds. You may find that even though each of your investee funds have caps on single stock exposure, a lot of them may be invested in the same stocks. This means that, on a look-through basis, your exposure level to those stocks may be imprudent.

This could be an issue with passive ETFs/index funds as well. For example, investing in both a Nifty 50 ETF and a Nifty 100 ETF may not be sufficient diversification. Since, the Nifty 100 ETF will also have a high allocation to Nifty 50 stocks. So, the appropriate diversification strategy in this case would be investing in Nifty 50 and Nifty Next 50 ETFs.

A cognitive bias that favours recent events is particularly dangerous when it comes to asset performance. “Past performance is no guarantee of future returns” may sound like white noise to most but in the interest of the long-term health of your portfolio, it is really important to fully assimilate it. Irrational exuberance and overexposure to any trendy asset class or security may not end well.

There is no one-size-fits-all type asset allocation. It depends on various factors like age, risk appetite, personal finances and circumstances. So, your friends’ asset allocation or something you pick up on a forum may not be right for you.

The objective of a sound asset allocation framework should be to be invested across multiple asset classes that are not correlated with each other. Typically, the asset classes available to a retail investor are: (i) Equity, (ii) Debt, (iii) Gold, (iv) Real Estate and more recently, (v) Crypto. Most investors are typically overexposed to 1-2 asset classes.

The first step is to determine the appropriate asset allocation and the next step, which is much harder, is to make sure you have the discipline to stick to that framework.