Avoid overweight risk in a portfolio

Why concentration, liquidity, inflation, and tax risk are risks to be avoided in a portfolio?

Often, I find investors confuse diversification with asset allocation. Being used to tracking equity markets or gold prices, investors believe diversifying between equities, bonds, gold, and real estate is good enough. But asset allocation and diversification are different. While asset allocation is allocating to different types of assets, diversification involves the number of each of those assets within your portfolio.

Asset allocation and diversification can help reduce the volatility in the portfolio. A well-diversified portfolio provides reasonable protection under normal market conditions. Diversification works because, in general, asset prices do not move perfectly together. However, diversification becomes less effective in extreme market conditions or in cases of over-diversification.

For diversification to work, investors need to avoid the following kinds of overweight risk in their portfolio.

Concentration to a few stocks or type of funds. These days, I find that investor portfolios are skewed towards large-cap securities in the form of stocks and large-cap/index mutual funds. A couple of years back when midcaps were doing well, investors had a bias towards these funds and have seen negative returns on their portfolio in the last few years. Clearly, diversifying with equities to large-cap and midcap is important to keep portfolio returns stable. The same holds while investing in index funds/ETFs. Within the same category of funds too, it is seen that investors hold funds with overlapping stocks. Before choosing a new fund, look at the overlap in stocks and sectors, with the existing funds, else it is not helping with diversification.

The ease of buying foreign stocks and fancy to FAANG stocks, has led to investors concentrating on international investments into these stocks. Diversification should also be geographic.

Another type of risk that is overlooked is liquidity risk. Those investors with a liking to real estate, tend to have most of their portfolio locked into property investments which are extremely illiquid. Covid-19 has shown why having the right amount of liquidity is imperative.

Within debt investments too, I find investors either invest in funds with high allocation to corporate bonds or high allocation to government bonds. The recent happenings in credit risk funds and the rally in government bonds showed that one cannot allocate to one type of debt fund. As per my analysis, I find short duration debt funds to be all-weather bond funds and a portfolio of different types of short duration debt funds should be good enough. Within short duration debt funds, some funds invest mainly in the best rated corporate and government bonds in varying degrees.

Indian investors are known to prefer on traditional investments like fixed deposits and ULIPs/ endowment policies. These investments do not beat inflation and being overweight on such products means the portfolio is not diversified to beat inflation risk and the tax risk. The tax risk is the chance that taxation of investment gains or losses can negatively affect the return on investment.

Here is what you need to do to assess the overweight risks in your portfolio:

1) Divide your portfolio by asset class to check the asset allocation

2) Within the asset classes, evaluate your investments by market cap (large, mid or smallcap), stock concentration, liquidity( how easy it is to exit the investment), taxation( if the investment is tax-efficient and is taxed at a rate lower than your tax slab) & inflation (does the investment beat inflation).

3) See if you can reduce costs in the portfolio by exiting very high-cost investments.

4) Rebalance the portfolio (over time) keeping in mind your goals and risk profile.