Diversification series 4 - Mitigate the downside risk with diversified equity

Diversification across asset classes mitigates risk as it helps to absorb shocks of volatility in the financial markets. However, diversification should not be restricted just to the different asset classes but also it crucial to spread investment within each of the asset classes. In the first article of the diversification series, we look at diversification within equity – an asset which has the ability to create wealth over the long term.  In short term, it can be highly volatile. While the systematic risk is beyond the investor control as it is affecting the broader market and difficult to predict like a coronavirus outbreak in 2019. Unsystematic risk is risk that is unique to a specific company or industry and can be mitigated by diversification. So how does one diversify within equity? Read more to find the answer.

Direct investing in equities

Indian equity benchmark – S&P BSE Sensex recorded a stellar performance in 2021. The year till date basis returns from Dec 31, 2020 to Nov 18, 2021 for the Indian equities shows Indian equities was the second-best performer with 25% returns, CAC 40 index was the top performer with 29% returns while DAX (Germany) delivered 18% returns. (See chart) The impressive returns of the index remain fascinating for investors evident from the rapid rise in the demat accounts. As on October 31, 2021, CDSL has 4.96 crore investor accounts while NSDL has 2.95 crore. [1] CDSL accounts grew at a compounded annual growth rate (CAGR) of 25% from 1.08 crore in FY 2015-16 to 3.34 crore in FY 2020-21. [2]

[1]Source: CDSL and NSDL

[2]Source: CDSL Annual report 2020-21

Source: Investing.com

While investing directly in equities, investors can get the exposure to spread across different market capitalisation (large, mid and small cap), sectors and companies. Equity markets are also well regulated, highly liquid instrument and ticket size of the stock varies. Investors get access to different market segment like cash, futures and options. Investors can also invest in the initial public offers (IPO). 2021 has been fantastic year for the IPO. According to EY, 72 IPO hit the equity market during January-September period this year in India with companies garnering $9.7 billion – highest for the 9-month period in 20 years. However, direct investing in equity calls for:

Direct investment calls for ability to deal with the market swings. Market phase analysis table shows several bull and bear periods. Equity is subjected to several types of risk like economic, market, political, sector or company specific risk, management etc. And these risk factors can bring in sharp volatility in the market causing massive downfall in the short run. But this volatility reduces when invested for the long-term horizon. S&P BSE Sensex has returned annualized returns of 14% in the 10-year period ended November 18, 2021. Hence, avoid market timing and remain invested for the long run.

Source: BSE

Large cap represented by S&P BSE Sensex, Midcap by S&P BSE Midcap and small cap by S&P BSE SmallCap

In Market phase analysis, returns for less than one year are absolute and more than one year is annualised

November 2021 data till November 18, 2021

Equity mutual funds

Direct investing in equities can be highly rewarding in event of the market uptrend but not everyone has the capacity to bear the huge losses when the market falls. In addition, investors may not have the expertise and time to track the markets. In such scenario, choosing an equity mutual fund is a better proposition.  

Merits and variety of equity mutual funds

The diversification and the professional management offered by the equity mutual funds can help to mitigate the risk. Mutual funds are highly liquid, well regulated, transparency, cost effective, harness the power of compounding by investing over long term. (See charts) Small amounts invested via SIP can give exposure to several stocks across sectors. Equity mutual funds have several variants and gives exposure to different market capitalization like large caps, mid-caps and small caps. Large cap funds are relatively less risky than midcap and small cap funds. Investor can also diversify across market caps through flexi cap and multi cap.  Further, they can get the opportunity to invest across different themes like ESG, infra funds and sectors like information technology, banking, finance etc.  In addition, there are different investment style such as active (returns are based on the fund manager’s ability), passive (take exposure to broader indices via index funds and exchange traded funds (ETFs).  Gold funds enable investors to get exposure to a commodity like gold and global funds helps to diversify in the global companies.

Source: SEBI and financial websites

Apart from the above merits, equity mutual funds can be your companion in the long-term wealth creation journey. Investing in equity mutual funds in the accumulation phase (age of 20 to 35 years) can help to adapt to the dynamic market environment and also reach the goals across life stages.  

For the illustrative purpose only, Mutual Fund Investments are subject to market risks and due diligence is must before investing

Notes: *Equity mutual funds returns is assumed as 14% which is an annualized return of S&P BSE Sensex over 10-year period ended November 18, 2021

Source: BSE and Mutualfundssahihai.com/en/calculators

Equity mutual funds is a market linked avenue and hence subjected to market risk. Performance may vary across times frames based on the performance of the underlying equity market benchmark  Hence, this avenue is ideal for investors having aggressive and moderately high-risk profile and long-term investment horizon. Check the suitability to your profile before investing. Avoid investing purely on basis of a rumour or advise from friend and relative. Seek an advice from the financial advisor and also check the fund’s performance in comparison to its benchmark and peers. Invest in a fund which has been consistent performer across market cycles. Check the scheme’s portfolio attributes, cost involved and fund manager details before investing. Seek a help of professional advisor, track the scheme performance once or twice in a year and hold on the investment for the long term.  (See below)

Factors to evaluate before investing in equity mutual funds:

• Personal risk appetite, goals and investment horizon
• Riskometer - a pictorial meter depicting the level of risk in a scheme
• Fund performance vis-a-vis benchmark and peers
• Portfolio attributes
• Consistent performer across market cycles
• Expense ratio, exit load charges
• Fund manager experience, team, AUM etc.
• Invest in new fund offer wisely
• Avoid overdiversification across many schemes

Taxability of the equity mutual funds

While investing in equity mutual fund, keep a check on the taxation as the capital gains on investment made are taxable. Capital gains on investment of less than one year attracts short term capital gains tax of 15% while capital gains earned over and above Rs 1 lakh after one year attract long term capital gains tax of 10%.

Ways to handle equity market volatility

Investing in equities be it directly or through mutual funds is rewarding in the long term but in the short run asset class is subject to high volatility. This volatility can create anxiety, fear, panic selling and investors taking hasty investment decisions which derails the long-term planning as well. So, whenever there is sudden and huge fall in the market as we also saw recently, it is essential to deal with it rationally and follow certain steps:

• Stick to your investment plan and don’t disrupt it amid short term volatility
• Keep a watch on the market events and movements which helps to evaluate if it is in line with your risk tolerance capacity
• Diversify within and across asset classes
• Frequent “buy low and sell high” can cause increased transaction cost instead long-term investing averages costs
• Use futures and options to hedge the market risk only after thorough research and expertise or else investor will have to incur huge losses
• Avoid market timing instead spend time and money on quality investments
• Doubtful, confused then don’t do anything…be patient and hold on your investment
• Talk to professional financial advisor

Summing up

Investing in equities can help to generate corpus which is crucial to attain key milestones across life stages. However, don’t fall prey to market volatility, rumours or just blindly invest in the market based on the tips from friends and relatives.  Apart from professional advice, do your own research invest in stocks and equity mutual funds which are in sync with your risk appetite and goals. Also note that in short run market falls sharply but it has the ability to rebound in response to positive factors in the long run. Hence, accept the market volatility, continue investing and hold on the investment for the longer horizon.