Illusion of Diversification in Stock Market

We must have all come across the term diversification at least once by now. Doesn’t matter if we invest in the stock market or not, the term has been fairly used for quite a while, across multiple mediums. But what does diversification in financial terms really mean?

To describe it in simple terms, diversification refers to the practice of spreading out one’s investments in order to limit the exposure to a specific type of asset. This concept helps in reducing volatility and overcoming the fluctuations that are common in the stock market.

Importance of Diversification in Stock Market

Diversification acts as the ultimate safeguard against the risk of a single investment bucket performing poorly or failing completely. For instance, if you had invested all your hard-earned money in the stock market, then there are chances that you might lose out on your empteen capital due to the stock market crash. 

Now when you diversify your investments across multiple asset classes, some might fall in value while some others would rise high to balance the loss. 

Hence, diversification lowers the portfolio risk because despite the harsh conditions in an economy, one or the other asset class will work and prove financially beneficial. 

Besides, diversification has psychological and mental benefits as well. Yes, you read that right! Market downturns can have a detrimental impact on the mental health of the investors. 

There have been instances when even seasonal investors have lost a major chunk of their fortunes due to a stock market crash. Post that they could not deal with the mental trauma and ended up either struggling with depression or worse. 

Hence, diversification not only safeguards your wealth but your mental health too. It is hence crucial and the need of the hour to have strategy that’s completely built upon the idea of allocating investments across multiple asset classes rather than just investing in the stocks without considering other options. This will help in cutting down on unwanted risks due to any possible stock market collapse.

And while diversification is commonly considered an advisable strategy, much of it depends on the market cycle.

Understanding Stock Performance During Market Cycle 

Market cycles, also called stock market cycles, refer to trends and patterns that the market experiences under different environments. During a cycle, it is generally observed that some assets outperform others due to business-affected factors. 

To dig deeper, market cycles undergo four phases. 

The accumulation phase refers to a situation where the market has bottomed and investors sense an opportunity to jump in and bag discounts. In the mark-up phase, the market indicates having leveled out. Here, the majority of early investors are jumping back in and the smart money is being cashed out. 

Sentiments turn slightly bearish in the distribution phase as prices are choppy. Here, the sellers prevail as the rally nears its end. Mark-down phase is the fourth phase of a market cycle where stragglers try to sell and salvage whatever they can earn. On the other hand, early adopters search for signs of a bottom so that they can invest back.

High Correlation During Bear Market

Several studies have proved that there is an increased correlation in global financial market returns during a bearish run. It is generally accepted that over time, returns are highly correlated when the markets experience negative movements than returns during normal times. 

Correlation can be used as a tool to gain insights into the overall macro nature of the stock market. For instance, a decade ago, several sectors in the S&P 500 exhibited a 95% correlation, beating the previous record set in 1987. The high correlation highlighted that they all moved in lockstep with each other. 

Back then, it was very difficult to pick stocks that outperformed the broader market. It was also difficult to select stocks across different sectors in an attempt to further diversify the portfolio. Investors had no choice but to look at other types of assets to manage their portfolio risk. 

Furthermore, high market correlation meant that investors could use simple index attempts in order to gain exposure to the market, rather than going through the trouble of selecting individual stocks. 

A similar situation was seen in India back in December last year. The country’s benchmark indices witnessed a 10% decline from their 52-weeks high. Sell-offs did have a greater impact on mid and small-cap shares, blue chips also bore the brunt. Large-cap stocks such as Tata Steel, Hindustan Zinc, Axis Bank, Indian Oil Corporation, ONGC, among others, witnessed a decline between 20% and 30% from their respective 52-weeks highs.

Some mid-cap stocks like Ujjivan Financial, Wockhardt, Bank of India, and PNB Housing halved from their 52-week highs.

During the 2008 financial crisis, stocks displayed a tendency to be more correlated despite belonging to different sectors. Similarly, international markets can also become highly correlated during times of instability wherein investors would want to include those assets in their portfolios that have a low market correlation with the stock markets in order to ward off risk. 

Correlation Between International Markets 

Having seen the high correlation during a bearish trend, it is also important to know that there exists a dynamic correlation between international markets too. For instance, in July this year, it was observed that stocks in India have been moving parallelly with their US peers at a very close pace since early 2021. Furthermore, there has been a 30-day correlation-coefficient measure between the NSE Nifty 50 and S&P 500 indices that reached 0.68 out of a possible 1.

Similarly, just like any other market, the Indian stock market is affected by any volatility in any part of the world. For instance, the war between Russia and Ukraine did have a negative impact in India. On 22nd February this year, the domestic benchmark indices - Nifty50 and Sensex - tanked by nearly 2% each to drop to 16,970.80 points and 56,876.85 points, respectively. Since 16th February, investors’ wealth has declined by INR 9.1 lakh crore ($121 billion).

So, why is Everything Correlated?

Much of the correlation is attributed to the globalization of economies. To simplify it further, the Indian economy is much closely linked to the economies of China, the USA, and Europe for that matter. When one economy slows down, we tend to purchase less stuff that has their origin in other countries. Thus, the other economies are impacted too and a chain reaction ensues. Moreover, every major company has global footprints today. Hence, a negative movement in one stock market has a direct and definite correlation on another market. 

So, how can you really de risk your investment portfolio via diversification?

Choose Asset Classes with Low Correlation, Diverse multi-asset investing

Including assets with low correlation in your portfolio helps in optimizing expected returns against certain risk parameters. Assets such as bonds and P2P lending help in reducing the quantum of overall risk for a portfolio.

For the past two decades, the returns from equities and bonds have largely been negatively correlated. This has benefitted multi-asset investors who have succeeded in reducing their portfolio risks and limiting losses in distressed market situations. 

Similarly, P2P pending is another asset class that has low to no correlation with the stock market. Moreover, this asset class is not considered volatile. 

The return in P2P lending is determined right when you invest in loans. Moreover, the return on your investment largely depends on the ability of the borrower to repay the loan.

Bottomline 

It’s important to scrutinize your investment portfolios carefully now that we have understood the diversification process and the correlation between international stock markets. If you plan to invest in asset classes that perform similarly, particularly during a downward movement in the market, then the answer would be no. Instead, invest in asset classes that demonstrate little to no correlation, thereby reducing portfolio volatility.