Investing in different asset classes based on their risk

One of the most oft repeated mantras in investing is diversification. Investment wisdom says don’t just own the stock of an umbrella maker — what if it stops raining? It’s for good reason that an investor who holds umbrella securities should ideally own some ice cream or sunscreen stocks too so that there’s room to make up for losses, or make gains, even when there’s no downpour.

There are basically two kinds of risks one needs to consider while investing — systematic risks and unsystematic risks. Systematic risk — a black swan event such as a global recession or a pandemic — could be mitigated by considering how volatile a security is compared to the wider market. To protect your portfolio against such risks you need to diversify by investing in asset classes that can absorb systemic shocks better. Unsystematic risk can be thought of as risks associated with a particular sector or company such as government regulation and disruption by a new entrant.

Asset Classes based on their Risk

Let’s look at a few asset classes considered less risky and essential to the diversification of a portfolio:

a) Gold

The yellow metal is the number one choice of safe harbour for an investor. Generally, when there’s an economic downturn or markets are crashing worldwide, investors take refuge in gold. Part of the reason why gold is so resilient is because it is thought to be something that will never go out of fashion — it will always be worth something. There are many ways to invest in it — one could own physical gold, buy gold stocks or invest in a gold fund. Gold bonds too are gaining popularity nowadays as a way of holding the precious metal.

Sovereign gold bonds are thought to be one of the best options as you can not only benefit from an increase in prices of the yellow metal but also avail a 2.5%  interest for the tenure of your holding. Gold bonds have a lock in period of eight years.

b) Government bonds

Government bonds are thought to be one of the most secure investments. The more stable a government and its fiscal math are, the smaller the risk associated with its bonds. This is why treasuries issued by the US government are one of the few asset classes that is a must have for big fund houses. It ensures that in the event that everything fails and no institution can keep their financial commitments, there’s at least one basket of investment which will uphold its promise.

c) Corporate bonds

Corporate bonds are debt instruments — you are a creditor to the company when you hold their corporate bond unlike stocks which qualify you as a part-owner. Though not as risk proof as gold and government bonds, corporate bonds are seen to be a significant part of diversification. Some of the biggest companies of the world are perceived to be as financially resilient as governments. Moreover, when the stock markets are crashing or a company goes bankrupt, holders of corporate bonds can still expect to make some gains. 

d) Multi Asset Funds

Multi-asset funds fall in the hybrid category of MF schemes and  invest at least 10% of their portfolio in a minimum of three asset classes. These funds generally have portfolios that are more diversified than traditional hybrid funds which invest in varying combinations of equities and bonds. Returns from financial assets like equity and bond markets tend to show greater co-movement and hence lower diversification benefits. As such adding asset classes such as gold, real estate and international equity,  whose returns show a lower correlation with traditional asset classes, could help lend a true multi-asset class flavour to your asset allocation. The good performance of any one of the underlying assets might help cushion against the poor performance of others.

Creating a diversified portfolio-

While the three investment avenues above are a great way to protect your money, they can never be good wealth creators. As such, it is important to keep one’s financial goals in mind and not go overboard with fixed income assets like bonds and gold while diversifying. There should be a healthy allocation to equities in different sectors, real estate, commodities etc.

Additional Read: Benefit of Asset Allocation in the Portfolio

Most individual investors would neither have the skills nor the inclination to track so many asset classes and redistribute allocations regularly. This is where a mutual fund helps. A mutual fund is basically a basket of investments across different asset classes and time frames bundled into a unit for individual investors. You can also choose to invest in a mutual fund that is more inclined to a certain risk profile or asset class. The best characteristic of a well balanced mutual fund is that for a small amount you can stay invested in a multitude of assets, giving your money the best chance to grow while also protecting it from the risk of an all eggs in one basket approach.

Additional Read: Understanding Mutual Fund Terminologies

If you are looking for a hassle-free way to diversify your portfolio, the Moneyfy app from Tata Capital is a great tool. You can invest in mutual funds and gold funds on the platform. It also helps you compare funds on the basis of category, investment horizon, returns et al.