Debates over how one's portfolio should be diversified can be endless. While some believe investing only in debt, others believe that equities are the way to go. Then there are those that would like a good mix of both.
A simple rule that investors could follow to allocate between equity and debt is comparing debt yields versus that of equities' (the inverse of the P/E ratio). At times when the markets are seemingly high, it would make sense to shift a certain amount of capital to high yields debt instruments. This could also be seen as a measure to keep aside cash, which could be made available to buy into stocks when equities seem attractive again.
In our view, diversification is important as various asset classes are either directly or inversely related. They further react differently to different events. In order to minimize the risk and volatility, it is important to keep one's holdings diversified. The trend of having exposure to non-traditional asset classes such as real estate, commodities and even art for that matter has started to gain popularity in recent times.
And now within these, it is important for investors to realize the need for further diversification.
For instance within equities, we at Equitymaster have maintained an asset allocation mix within large, mid and smallcap stocks in the range of 50% to 60%, 25% to 30% and 5% to 10% respectively. And within each category we recommend investors not to have too much exposure to individual stocks to curb risks.
In short, the rule that no stock should form more than 5% to 10% of one's portfolio should be maintained in our view.
So what should be the ideal mix between various asset classes?
Well, this would largely depend on each individual. For instance, in order to meet very short term financial obligations, best would be to keep money in cash or liquid instruments. For financial expenses which are a few months away to a period of about two to three years away, investing in a relatively risky asset classes such as equities would not be the best way. One should instead invest in debt instruments.
Exposure to equities should be there for major portion of the balance amounts. Not to mention that it would be advisable to keep about 5% to 10% exposure to gold, as a tool for hedge against inflation.
While diversification is recommended, investors should avoid going overboard on diversification. They should stay away from investments or asset classes they don't understand. For example, real estate investments are not for everyone given the large sums required investing in land or properties and the risks involved. Further, they should not compromise on the quality in an attempt to be more diversified.