3 Key Factors To Consider While Building A Diversified Portfolio

2023 saw small-cap stocks emerge as the most popular equity category among investors with the Nifty Small 100-TRI index delivering mouthwatering returns of 56.66%. In comparison, the Nifty Midcap 100-TRI posted an attractive 47%, but the large-cap Nifty 50-TRI was a laggard with relatively modest 21% returns.

Such outperformance in a single year is rare, however. And, retail investors, who tend to follow the herd - they pumped in a net Rs 12,052 crore in small-cap mutual funds in October-December 2023 as compared to net inflows of Rs 750 crore in large-cap funds - ought to tread with care.

After all, small caps are inherently a high-risk, high-return category. They are also illiquid and price-sensitive to large orders, and investors can get caught on the wrong foot. Investors should instead look beyond headline returns and adopt portfolio diversification across asset classes, categories, and sectors as their bedrock risk management strategy.

Markets are cyclical and the performance of different asset classes - and sectors - varies each year. In 2019, for instance, small-caps gave negative 8.98% returns while large-caps zoomed up 12.65%, and gold topped the charts with 21.1% returns. Or take the rebound in equities in 2023. This came on the heels of a dismal 2022, when small caps fell 1.8%, large caps posted barely 4.4% returns, and gold proved to be the heady safe haven with 11.7% returns.

Similarly, while consumption-led stocks were the flavour of the day before the pandemic, infrastructure and capital goods sectors have soared post-2020-levels as government-led capital expenditure has powered the economy.
As the old adage goes, do not put all your eggs in one basket.

How should you diversify?

While investors should limit their exposure to a single asset class, sector, and stock to reduce risks, there is no one-size-fits-all formula for portfolio diversification.

Instead, investors must consider three factors - their risk appetite, financial liabilities, and tax slab - to arrive at an appropriate portfolio mix across equity, fixed income, gold, real estate, global markets, and other asset classes.
For instance, a 24-year-old with no financial liabilities and a runway of 30-40 years could invest a major portion of their equity portfolio in small caps, which provide superior returns, but at a higher risk, over the long term.

On the other hand, the old formula of reducing equity investments and increasing fixed-income holdings as one approaches retirement may not hold true for an individual who has accumulated a large corpus or one who has a steady income stream to take care of monthly expenses. Lifespans have increased and at 60, an individual may still have a runway of 10-20 years, so they could continue to invest in equity.

The other factor to consider is the investor's tax slab. Fixed deposits with an interest rate of 6%-7% may not provide inflation-beating returns to an investor who is in the 30% tax slab. But they may be appropriate for a senior citizen who is in a lower tax slab and needs a liquid investment. The former investor could choose large-cap funds, which have given historical returns of 10%-11% on average in the long term and which carry a capital gains tax of just 10%.

These three factors apart, valuations and timing also matter - even though it is impossible to time the market always. For instance, debt mutual funds posted poor returns in the rising rate environment of 2021 and 2022 with gilt funds appreciating by only 2.2% in 2021. Just the previous year, though, gilt funds gave 12.8% returns as the pandemic induced central banks globally to cut rates. Investors who timed their entry into gilt funds in 2020 benefited as bond prices rose.

Looking ahead

Going forward, the strong India growth story is expected to sustain the momentum in equities in 2024, especially if there is continuity of the government at the Centre and if the budget keeps providing a push to infrastructure spending.

At current valuations, large caps look promising, while returns on small caps could moderate in 2024 given their high valuations. Capex-linked sectors like metals, power and cement are also likely to do well in the current year.
On the debt side, some softening in rates is likely in the second half of the year on the back of abating inflation, lower government borrowings, and higher foreign fund inflows with India's inclusion in the JP Morgan emerging market government bond index. This could cause the yield curve to shift lower, boosting bond returns.

Meanwhile, geopolitical tensions continue to pose the biggest risk to global markets, heightening volatility. In such a scenario, what better way to beat volatility and manage risks than through portfolio diversification?