During periods of market corrections, many investors succumb to panic selling, ultimately crystallizing losses that could have been mitigated. Portfolio diversification can serve as an effective strategy to buffer against systemic risks and enhance risk-adjusted returns in these uncertain times.
What many fail to realize is that even during downturns, a portfolio can still perform well if its drawdown is smaller than the broader market’s drawdown. In today’s unpredictable financial environment, understanding and managing different types of risk is crucial to building a resilient, all-weather portfolio. In this article, we will explore certain ways how to construct an all-weather portfolio.
Risk in financial markets is generally categorized as systematic and unsystematic. Systematic risk affects the entire market and is influenced by factors such as interest rate changes, or global events like the 2008 financial crisis and the COVID-19 pandemic.
Unsystematic risk, however, is specific to individual companies or industries. For instance, a regulatory change affecting the telecom sector would impact only those companies but not others. While systematic risk cannot be fully eliminated, unsystematic risk can be mitigated through effective risk management.
Diversification is one of the fundamental principles of investing that helps investors manage risk while maximizing potential returns. For Indian investors, a well-diversified portfolio is crucial to navigating the inherent volatility of the stock market. A key element in understanding diversification is the risk-return tradeoff, which lies at the heart of portfolio management. By spreading investments across non-correlated asset classes such as equities, commodities, and bonds investors can reduce their exposure to unsystematic risks. For Indian investors, one of the strategies to manage systematic risk is by building an optimal portfolio which means combining asset classes with different risk profiles such as equities, commodities, and bonds. The key is to include assets that are not correlated, meaning they do not move in the same direction at the same time. For example, while equities might rise during a bullish phase, commodities like gold often perform well in times of uncertainty, offering a hedge against stock market volatility.A diversified portfolio in non-correlated assets tends to experience smaller drawdowns during market downturns. When one type of investment goes down, others might stay stable or even go up, balancing out the overall impact. This way, the portfolio experiences smaller losses compared to investing in just one or similar types of assets that may all drop at the same time during a downturn.
One of the lesser-discussed yet highly valuable metrics in portfolio management is the Calmar Ratio. This ratio measures the annualized return on investment relative to the portfolio’s maximum drawdown, thus evaluating portfolio performance in terms of risk. A higher Calmar Ratio indicates a better risk-adjusted return, as it reflects the portfolio’s ability to generate returns while minimizing large declines.
Diversification plays a key role in improving the Calmar Ratio. This, in turn, lowers the portfolio’s volatility and enhances its Calmar Ratio, making it more resilient in the face of market fluctuations.
Consider the below example: The first chart shows that the S&P BSE Midcap Index delivered a 17.2% CAGR over 10 years but suffered a significant -40.79% drawdown during COVID. In contrast, the second chart, with a diversified portfolio of 60% MidCap and 40% Gold, achieved a 14.9% CAGR with a much smaller -14.06% drawdown. By allocating 40% of the portfolio to gold, we successfully reduced the drawdown from -41% to -14%, while maintaining a CAGR of 14%.
ETMarkets.comFurther, the Calmar Ratio is higher for the diversified portfolio (1.00) compared to the pure MidCap portfolio (0.42), highlighting the reduced risk and better stability. This demonstrates how diversification can reduce volatility and provide more stable returns, particularly in times of market stress like COVID.
An investor can select an optimal portfolio and allocate funds according to their risk tolerance. The table below illustrates how changes in the allocation between a risky asset (Midcaps) and a safe asset (Gold) impacts the CAGR, drawdown, and Calmar ratio.
ETMarkets.comA balanced portfolio must include high-growth equities for capital appreciation, along with other non-correlated asset classes to stabilize returns during periods of market volatility. Hence, diversification is crucial for Indian investors looking to balance risk and return in a volatile market environment. Furthermore, investors can achieve better risk-adjusted returns by focusing on the Calmar Ratio and reducing portfolio drawdowns.