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Portfolio construction basics: sources of risk

Posted on 20 Mar 2022
Author: Sayan Sircar

Tags: Portfolio Construction ; Asset Allocation

6 mins read

Risk and return go hand in hand, and a portfolio requires a balanced representation from various sources of risk to generate returns.

Portfolio construction basics: sources of risk

📚 Topics covered:

Risk and rewards
- Defining risk and seeing its result
- Higher risk does not always mean higher returns
Sources of risk

Risk and rewards

Defining risk and seeing its result

In investing, risk is defined as the variability of returns with time. In simple words, it means that stock, bond, and real estate markets go up and down with time. These fluctuations, also known as volatility, provide the opportunity that returns will be high as well as low. Therefore, the more sources of risk you have in your portfolio, the more is the chance that all of them will not go up and down simultaneously.

We show a chart based on the yearly return of assets classes from 2010 to 2021 using Valueresearchonline data.

Returns from various asset classes

This chart shows that:

there is no consistency in the returns from the various asset classes
a portfolio that invests equally in all of these asset classes stays near the middle of the pack and avoids both extremes

Higher risk does not always mean higher returns

A common misconception amongst investors is that increased risk will increase returns. However, if the return is always high, the risk is low and not high since there is a low chance of variation. We use the same data as the chart above to show the impact on returns on taking more or less risk.

High returns imply higher risk

Some points to be noted here:

the chart is sorted on descending risk value measured by the variation of the yearly returns
the higher the risk, the more is the positive gains and more is the negative loss
as an asset class, gold has given returns very close to equity than debt at a risk level comparable to equity
an equal-weighted portfolio of all of these eight asset classes has given returns comparable to large-cap equity at a considerable lower amount of risk

Investors who specifically load up on small and mid-cap funds to get higher returns should spend some time consulting this chart and be comfortable with the 30%+ falls that come along with the 60%+ gains. A strategic asset allocation plan with a diversified mix of multiple asset classes has a better potential to reach financial goals than one that is overexposed to any one of these factors.

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Sources of risk

We can use a diagram like this to visualize the universe of investible asset classes, which you can use to create a portfolio. Typically we will have:

equity via direct investment in stocks or via mutual funds
debt via purchasing in bonds or via mutual funds
real estate via residential and commercial real estate or REITs
gold via jewellery, SGB, or gold mutual funds
alternatives like precious metals (e.g. silver funds are now there in India), art, private equity, et al

Equity

Sources of risk in equity

In the equity bucket, we have large, mid and small-cap stocks based on the market capitalization of the stocks. In India, we have six categories of funds based on various combinations of stock sizes in the portfolio. In addition, we have a large number of additional types like factor-based (like Momentum, Low Volatility), Sectors (like Auto, Pharma) and Thematic (like Consumption, MNC) funds.

Debt

In debt, we have various categories of investments:

bank deposits like FD/RD are considered low risk and are guaranteed up to 5 lakhs under DIGC insurance
bond investments with various types of credit quality. Gilts, i.e. government bonds, are considered the safest, followed by SDL (State Government Loans), Corporate, and more recently, asset-backed securities
bonds are also classified based on the duration of lending, which determines how the price of the bonds fluctuate with interest rates
government schemes like Provident Fund and Sukanya Samridhhi that offer a fixed interest rate

Gold

Gold is an interesting asset since gold does not generate any income. This behaviour is unlike assets like stocks (via dividends), bonds (via coupons), real estate (via rent) or fixed deposits (via interest). Given how recurring cash flows like in the cases above are used to value assets like stocks, bonds and real estate, there is no way to value gold beyond hoping for a buyer to buy it at a higher price in the future.

Diversifying a stock portfolio with gold

Gold can be used to diversify a portfolio of stocks and bonds, as shown below by slowly adding gold to a stock portfolio. As the proportion of gold increases, the portfolio risk decreases up to a limit and then increases again. We have covered the topic of gold investing in detail in this post: What is the best way to invest in gold?

Real estate

Real estate is an attractive investment option for many people because of rental income, price appreciation and the feel-good factor of owning a tangible asset. We exclude the primary residence here since it is a part of the net worth but does not belong to the investment portfolio.

The flip side, apart from the illiquid nature and lack of regulation, is the ticket size. While you can purchase financial assets like stocks and mutual funds starting at a few hundreds, real estate is priced at ticket sizes starting at multiple lakhs. Basically, if you are starting with a ₹10,000/month SIP, it is not possible to get exposure to real estate directly at say ₹2,000/month. REITs, fractional commercial real estate, and REIT based FoFs (see Should you invest in PGIM Real Estate fund NFO?) are now available in India. Investors should perform thorough due diligence in case they are investing in products that are not SEBI regulated.

Alternative investments

Art, wine, precious metals, structured products, P2P lending and commodities are just some of the alternative investments available to investors based on their status as retail, HNI or accredited investors.

In a future article, we will cover how to combine these asset classes to create a portfolio for long- and short-term goals.

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