I am in my 30s. If I diversify my equity holdings by sector, market cap, AMC, industry, investment style and geography, is it justified to have a portfolio of 90% in equity?
Diversification is a risk-mitigation strategy that involves allocating exposure to different securities/asset classes which are impacted by different fundamental drivers. It aims to lower overall portfolio volatility and mitigate the risk of extreme drawdowns. Diversification looks to achieve an optimal risk-to-reward ratio.
Diversification works only when the assets in a portfolio respond differently to the same set of fundamental/economic drivers. For example, an investment in two different auto stocks would not be sound diversification, since both are likely to witness sharp falls during times of economic downturn. On the other hand, adding consumer defensive stocks to the portfolio of auto stocks would serve as a cushion during downturns, as these are likely to fall less due to the lower demand elasticity of the products.
Even though a portfolio may be well-diversified across variables such sectors, industry, market-cap, asset management companies, investment style and geographies, the portfolio may still be subject to drawdowns as most securities within an asset class respond similarly to some extent to the same set of economic drivers.
Ultimately, this is a very personal choice. You have to consider your reaction to volatility in conjunction with your circumstances. For example, if you are about to retire, a pure debt portfolio is not a smart option because you do need some equity exposure to grow your wealth. Someone in their 20s may shun from an all-equity portfolio because they cannot stomach volatility. On the other hand, someone in their 30s who is not perturbed by volatility and has a very long-term goal, can opt for a pure equity portfolio to capitalize on the long-term uptrend.
Having said that, individuals exaggerate their ability to weather years and years of subpar returns and gut-wrenching market dips and terrible losses. To see all your hard-earned money drop in value is not easy to digest.
Equity allocation is a function of the risk-appetite of an investor, and in turn, depends on his ability and willingness to take risk.
The ability to take risk depends on factors such as income, wealth, liabilities, time horizon, etc. Higher the investment horizon and risk appetite, higher can be the allocation to riskier asset classes such as equity which have the potential to deliver relatively higher returns compared to fixed income over the long term.
One should get the risk suitability assessment done which would help in identifying an appropriate risk profile. We honestly believe you must consult your financial adviser before making such a decision.
Final word of caution: Should you decide to opt for an all-equity portfolio, please ensure that you create an Emergency Fund. Or else, if you need the money you may be forced to sell your stocks at ridiculously low prices. Please read 4 questions on Emergency Funds answered.
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