Is your portfolio truly diversified? Unveiling the significance of ‘factor’ diversification

Don’t put all of your eggs in a single basket. We’ve all heard that. This recommendation stems from the unlucky situation the place, ought to the basket fall, all of your eggs will break.

This final result is unlucky but completely preventable. The important thing? Put your eggs in several baskets. That manner, ought to one basket tumble, the opposite eggs stay protected.

However what if all of your baskets relaxation on the identical tray?

If the tray topples, all of your eggs will probably be crushed, even if you happen to adhere to the knowledge of spreading them throughout baskets.

In investing parlance, the hampers characterize securities, and the trays symbolize sectors. Due to this fact, it isn’t solely suggested to unfold your investments throughout completely different shares but in addition completely different sectors.

This precept is extensively accepted, however sectors should not the one type of trays that want diversification. A lesser-known tray is ‘elements’. You might need diversified away from sectors, however you might be in bother if all of your shares are nonetheless uncovered to the identical issue, and it’s a boring time for that issue.One other nuance to that is that diversification ought to happen in negatively correlated areas. It wouldn’t matter when you’ve got diversified over a whole bunch of baskets or trays; if they’re extremely correlated, the entire goal of diversification will get defeated.However allow us to put this to the take a look at. What does diversification of things appear like, and which various factors have detrimental correlations?

Detrimental Correlation: The Intricacies of Components at Play

Ever seen a see-saw? One aspect goes down, the opposite goes up – easy physics. Finance, although, is not that easy. However, there are some observable patterns, particularly in the case of elements like Worth and Momentum.

Allow us to break it down. Momentum is all about shares on a profitable streak, whereas Worth says cheaper shares have their day in the long term.

Each have been tried and examined over a long time, however current a dichotomy.

Think about a inventory’s worth is hovering. It is bought excessive Momentum, which means it retains doing nicely. However weirdly, it’s additionally getting pricier in comparison with its actual worth, assuming nothing main adjustments. On the flip aspect, a beaten-down inventory might need a low Momentum rating however is getting cheaper in comparison with its actual worth.

Ah, the dichotomy! You may’t have them each, or are you able to? Extra on that later.

However to show this speculation, we did some quantity crunching on the highest and backside 50 performing shares within the Nifty 500 universe from January 1, 2023, to December 31, 2023.

We sorted the universe primarily based on their inventory worth returns for the above interval after which grouped them into 10 deciles from D1 to D10.

Lastly, on a scale of 0-100 for every issue, we noticed how momentum and worth scores modified for the D1 and D10 portfolios of shares on common.

The highest-performing shares (D1) noticed their Worth rating fall by ~12% whereas Momentum climbed by ~26% throughout 2023. The destiny was the precise reverse for the worst-performing shares (D10).

(Notice: Share.Market Quant Analysis conducts intensive computations throughout hundreds of information factors for each safety throughout the Indian inventory market universe. Subsequently, we rating and rank every safety primarily based on numerous elements as a part of our analysis course of.)

This proved our speculation that these two elements are certainly negatively correlated. Now allow us to take it a step forward and discover out if we had been to construct a composite (50:50) portfolio of the 2 elements, would we be higher off or not?

Constructing a (Issue) Diversified Portfolio

Within the pursuit of our analysis aims, we assembled three distinct portfolios inside our universe:Momentum Portfolio – Comprising shares with the best Momentum scores.Worth Portfolio – Encompassing shares with the best scores within the Worth issue.Composite Portfolio – Constructed by combining half the shares from the Momentum portfolio and the remaining half from the Worth issue, aiming to merge the perfect of each worlds.These portfolios had been constructed in a way such that they’re beta-neutral, subsequently displaying the issue efficiency devoid of any extraneous noise. In different phrases, we made certain that these portfolios weren’t impacted by general market motion, however moved solely due to their issue efficiency.

And the outcomes had been nothing wanting exceptional!

(Notice: Previous Efficiency shouldn’t be indicative of future outcomes)

Upon plotting the efficiency of all three portfolios on a chart, the synergy between Worth and Momentum turned evident.

During times of Momentum underperformance, like in 2016, Worth stepped in, sustaining the composite portfolio’s respectable returns whereas standalone Momentum skilled detrimental returns. Conversely, throughout 2019, when Worth confronted challenges, Momentum rescued the composite portfolio.

Here is the icing on the cake: the union of those negatively correlated elements resulted within the composite portfolio having decrease danger than each the Momentum and Worth portfolios.

All through our analysis interval, the composite portfolio constantly boasted the least rolling normal deviation of the three. Even throughout the post-COVID spike, the composite portfolio remained a safer choice for buyers.

Key Observations:

By way of pure returns over the previous decade, Momentum > Composite > Worth.By way of pure dangers and volatility, Momentum > Worth > Composite.The Composite portfolio tried to ship Momentum-like returns with out assuming a number of danger. Being the least dangerous of all, it emerged because the optimum alternative, delivering a well-rounded proposition when it comes to each return potential and security.

Conclusion

Diversification is not only a golden rule; it is a common precept that may considerably profit buyers. The affect of things diversification on a portfolio persists, whether or not or not you incorporate them in your stock-picking course of.

So, even if you happen to comply with a discretionary strategy, handpicking shares primarily based on a customized funding course of, the significance of an element lens can’t be overstated. It serves as an important software to gauge focus ranges and assess the related dangers throughout the portfolio.

(The creator is CIO, Share.Market)

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