Tag: diversification

Diversification and its Malcontents

Study history but use commonsense.

Every advisor you speak to likely extolls the virtues of diversification. “Buy stocks, bonds, gold, real-estate in x/y/z proportion.” Since no one can predict future returns of individual assets, by buying all of them, investors can protect themselves from steep drawdowns.

But what exactly is “diversification?” Is it right for you? Over what assets should you diversify? And how long should you wait before you expect to see the benefits of such diversification?

There are several theories on sex and all of them are lies. – Santosh Kalwar

Before we dive into the how/what/when, let’s set the backdrop through which we’ll discuss the topic.

American Exceptionalism

Most portfolio research is conducted with US Dollar assets trading in America. It is then ported over unquestioningly to other markets. However, there is no other country like America – the only country in the world that can print US Dollars that every other country in the world needs to hold as a reserve asset. This gives US assets a steady, unrelenting bid.

For example, government bonds are supposed to be low-volatility assets with limited downside. However, Indian investors have a completely different experience compared to Americans with it comes to investing in them. Here’s the rolling 3-year standard deviation of weekly returns of Indian 10-year gilts (in USD) and a US fixed-income fund for comparison.

Not only are Indian bonds more volatile, they have +30% drawdowns that take years to recover.

In a flight-to-safety, Indian bonds get sold and American bonds get bought.

The 60/40 Buy and Hold

Since the mid-90’s, an American investing in American assets did spectacularly well. Not just in equities…

… but in bonds as well.

An US-based advisor can be excused for beating the drum of buy-and-hold. After all, US equities and bonds have always recovered. And they can afford to keep-it-simple with a static 60/40 allocation between stocks and bonds.

However, look at the performance of Emerging Market (EM) equities and bonds. An absolute disaster both in terms of returns and volatility.

So, when advisors wax eloquent of the 60/40 portfolio, what they really mean is US Equity/US Bond 60/40 portfolio. Investors in the rest of the world, especially in EMs like India, will do well to formulate a strategy that works given their reality rather than blindly following US-centric allocations and strategies.

King Dollar

While the US Dollar has appreciated against most currencies since 2010, it is nothing compared to how much it has appreciated against the Indian Rupee.

A falling currency is a headwind against a portfolio trying to preserve purchasing power and presents a performance hurdle of sorts.

While USDINR is not the worst currency pair out there, it pays to think of portfolios in Dollar terms.

The Streetlight Effect

A policeman sees a drunk man searching for something under a streetlight and asks what the drunk has lost. He says he lost his keys and they both look under the streetlight together. After a few minutes the policeman asks if he is sure he lost them here, and the drunk replies, no, that he lost them in the park. The policeman asks why he is searching here, and the drunk replies, “this is where the light is.”


The Center for Research in Security Prices (CRSP) was founded in 1960. They went live in 1964. Initially, the center’s database consisted of monthly share prices of common stock trading on the NYSE, dating back to 1926. Over time, the database grew in size, introducing other exchanges and securities, as well as daily updates.

In India, the Total Return NSE mid-cap index prices are available only from 2005. In search of robustness, researchers use US datasets by default. However, every market is different because the political backdrop in which they operate are different. It is called the political economy for a reason. So, before taking US financial research at face-value, it behooves us to understand the qualitative drivers behind the numbers: are regulation, politics and market structure similar enough for the data-set being analyzed that the conclusions can be applied to the target market?

Besides, with limited datasets, it is easy to play games by cherry-picking data and begin/end dates to fit a narrative. Here is a sample:



While trying to figure out the right asset mix and investment strategy, Indian investors have to recognize that they may be looking through a tinted window, at a small dataset.

The Allure of Commodities

The theory behind investing in commodities is that they offer an inflation hedge unmatched by most other asset classes. While the relationship between commodities and equities varies considerably – at times there is a negative correlation – on average, they show a low but positive correlation.

Here comes the BUT: the dataset used to analyze these relationships largely covers prices before commodities were financialized, democratized and packaged into ETFs that can be traded by mom-and-pop investors by the click of a button.

While some advisors may hold onto the trope that commodities “work” if actively managed, historical performance of such funds have been a disaster.

The best way to become a millionaire is to start with a billion dollars and invest in commodities.


While diversification is often recommended as a “free lunch” that every investor can partake, a lot depends on the assets that go into the basket. Each one of them have “worked” in the past for different reasons. Increasing financialization means that assets that were uncorrelated in the past because of trading friction suddenly become correlated during market panics. Currency depreciation is a real problem for Indian investors, silently eroding purchasing power.

Portfolio construction should be done against this backdrop – not blindly throwing together a bunch of assets and hoping that it works. We will discuss some of these approaches in subsequent posts.

Mitigating Sequence Risk through Asset Allocation

Sequence Risk (sometimes called sequence-of-returns risk) is the effect that the order of returns has on a portfolio.

For example, say you look at NIFTY and find that it gave negative 10% returns 4 years out of 10, and the rest of the years it gave positive 10% returns. You want to be invested for 5 years, so you expect 2 of those years to be negative. Sequence risk means that it is possible that you could have all of those negative 4 years during the 5 year period that you have invested.

The order in which losses occur impacts the portfolio’s terminal value

The annualized return of the NIFTY 50 TR index, since inception through May-2020, is roughly 12%. However, it has not been without periods where it was down over 50%.

NIFY 50 TR cumulative returns since inception

The lower part of the chart shows the drawdowns that have occurred in the past. Sometimes, it has taken years to recover from losses. The problem is that most investors have a pre-defined time-frame in mind. They want to be invested, say, for 10 years. Not “forever.” This is where sequence risk becomes a problem.

For a 10-year period, if you re-sample the monthly returns of the NIFTY 50 TR index and re-construct a return time-series, say, a 100 times, and plot the cumulative returns of each, it looks something like this:

The blue line is the “average” monthly return compounded for 10-years

Put another way, there is a non-trivial chance that an investor could end up with negative returns in a given 10-year period even if NIFTY’s return distribution did not change.

So, what is an investor to do? There are two approaches that have known to work:

  1. Diversification. Allocate to non-correlated assets.
  2. Get Tactical. Markets are known to trend. Try and preemptively exit from assets who’s prices are trending down.

There are a million different ways to skin each of these approaches. The simplest one is to add bonds to the portfolio.

NIFTY 50 TR and 0-5yr TRI

Bonds, especially sovereign bonds (issued by stable countries, of course) have very low drawdowns. So when you combine it with equities, you end up with a lot less sequence risk than pure equities.

If you simulate different proportions of equities and bonds and plot them along with their standard deviations, you’ll get an idea of where to trade-off stability with returns.

Trade-off between risk and returns

Let’s say that the sweet-spot is equity/bond ratios with avg. returns more than 10% but lower-bounded at 7.5%, you get 45/55, 50/50 and 55/45 as ideal allocations. While a 60/40 equity/bond allocation is the go-to for most advisors, there is no reason why it can’t be a more conservative 45/55.

Cumulative returns of different allocation ratios

Note the lower drawdowns of diversified portfolios. While the equity-only portfolio would have had an annualized return of 11.88% during the period, diversified portfolios ranged from 10.10% – 10.56%. The trade-off is that diversified portfolios have vastly less sequence risk.

The left-tail has been flattened while returns are now clustered more towards the average

Diversification changes the shape of the return distribution so that an average investor has a greater probability of experiencing average returns.

Read more about portfolio allocation across different assets here.

Code and images are on github.

Indian vs. US Mid-caps

There used to be a time when getting your kids through college was the final act before kicking them out of the house. But kids these days want their parents to fund their US education as well. And how about a gap year to travel through Europe? You can roll your eyes all that you want but 15-20 years from now, this will be the new normal for middle-class Indians. What can we do? We have always been an aspirational lot and it is bound to rub off on our kids. As much as we like our kids to be financially independent when they grow up, we also don’t want them to start their lives with a ton of student loans. However, given the potentially large dollar liabilities in the future, most Indian investors continue to keep all their eggs in the Indian rupee basket. If you think your Indian mid-cap mutual fund alone is going to fund your kid’s grad school, think again.

Not only have Indian Mid-caps trailed US Mid-caps over the last 25 years, they have done so with steeper and longer drawdowns.

Over the last 25 years or so, US mid-caps have out-performed Indian mid-caps. Indian asset managers would have you believe that “east or west, India is the best” but that is not what the numbers say. Here are the cumulative and annual returns of the MSCI India MC and MSCI USA MC indices:
MSCI India vs. US mid-cap indices
MSCI India vs. US mid-cap indices

Living in India, it is easy to get carried away with stories about how Indian equities present big opportunities. However, historical returns show that investors were not compensated for the additional risk that they took by investing in India. Also, the US equity market cap is 50% of the total world equity market cap. So even if you have bonds, gold etc in your portfolio, being 100% invested in India is not true diversification. Besides, the Indian rupee keeps depreciating, making your future dollar liabilities that much larger when priced in local assets.

We ran through different allocations between Indian and US mid-caps to get an idea of what the potential returns could look like:
Allocating between MSCI India vs. US mid-cap indices

Assuming a monthly rebalance, the 50/50 portfolio beats the “all in” 100/0 and 0/100 portfolios. And it does so with shallower drawdowns. So both from a diversification and returns point of view, it makes sense to allocate towards US mid-caps.

It is time to have a chat about your portfolio. Get in touch with us now!

Further reading: Funding Your Dollar Dreams

Asset Allocation


How does an equity/bond 2-asset portfolio look like?
Read: Allocating a Two-Asset Portfolio

A three asset portfolio

Indian midcaps + bonds with Nasdaq-100 ETF. Is there a benefit to using portfolio optimization algorithms after taxes and transaction costs are taken into account?
Read: Allocating a Three-Asset Portfolio, Equal Weighted and Allocating a Three-Asset Portfolio, Optimized

Adding gold into the mix

Does gold have a role to play in a systematic, diversified portfolio?
Read: Allocating a Four-Asset Portfolio

Investing in a systematic, diversified portfolio

A ready-to-invest Theme, the EQUAL-III, that takes care of keeping track of everything.
Read: The EQUAL-III Theme

Expected Returns

What are the range of expected SIP returns under prudent asset allocation schemes?
Read: SIP: Expected Returns


Our recent series on asset allocation walked through how different investment decisions affect portfolio returns and risk.

  1. Number of assets: Three is better than two and four.
  2. Rebalance threshold: Allowing a single asset to drift upto 80% reduces transaction costs and taxes.
  3. Weighing scheme: Equal weight is better than portfolio optimization methods.

You can read through the posts and the various factors that went into the analysis in order:

  1. Allocating a Two-Asset Portfolio
  2. Allocating a Three-Asset Portfolio, Equal Weighted
  3. Allocating a Three-Asset Portfolio, Optimized
  4. Allocating a Four-Asset Portfolio

For investors looking to gain from such a portfolio, we have setup a ready-to-invest Theme, the EQUAL-III, that takes care of keeping track of everything. It maintains an equal-weight portfolio of the M100 (Midcap-100 ETF,) N100 (Nasdaq-100 ETF) and the RRSLGETF (Long Term Gilt ETF.)

Questions? WhatsApp us +91-80-2665-0232