Seven things NRIs need to know about diversifying their investment portfolio

Diversification, also known as the ‘don’t put all of your eggs in one basket’ theory of investing, is one of the most important concepts for any investor. However, for non-resident Indians (NRIs) there can be even more factors to consider when creating an investment portfolio.

Earlier this month Taher Fakhri, Friends Provident International's (FPI) Middle East regional compliance and risk office, penned a Your Money blog urging NRIs to diversify away from just gold and property.

Here, Mr Fakhri reveals seven tips to help NRIs living in the UAE choose the right mix of investments for a portfolio:

1. A conventionally diversified portfolio contains six asset classes: stocks, bonds, property, cash, commodities and alternative investments

Part of the art of investing comes in the way these asset classes are held; the geographic location of the investments and the proportion invested in each.

Stocks and bonds, for example, may be held directly or in mutual funds or ‘collectives’ as they are sometimes called because they are owned by a collective of investors; property and commodities too, are commonly held in these ways.

‘Alternative investments’ are less an asset class and more a broad category that can include everything from hedge funds to financial contracts such as derivatives, stamps or collectables. A common characteristic of ‘alternatives’ is that their price or value should behave differently to, or have a low or negative correlation with, more mainstream investments such as equities and bonds.

The proportions of each of these asset classes investors hold are likely to vary with personal circumstances, investment goals and attitudes to risk, but prudent investors may limit their exposure to higher-risk assets as they get closer to achieving a saving/investing goal.

2. Investing in mutual funds doesn’t automatically result in diversification

Mutual funds are one of the most common structures through which people invest in different assets. They are popular because they are professionally managed, usually ‘liquid’, so people can access their money relatively easily, allow people to pool their wealth to optimise its growth potential and achieve greater diversification across a larger number of underlying holdings. They can also offer a degree of security and peace of mind through being subject to various rules and are usually overseen by a financial regulator.

When it comes to diversification, though, a key point to remember is that you can choose 10 different mutual funds and still be undiversified. A portfolio of mutual funds is unlikely to be considered diversified if all the funds invested in stocks in the same market or country; or stocks in different markets but in the same industry.

3. Avoid ‘correlation’

The value of different asset classes and investments around the world rises and falls every day in response to any number of events. One measure of a well-diversified portfolio is how little some components of it are affected by developments that have a strong effect on another part.

The more the various investments in a single portfolio rise and fall together, the more they are said to be ‘correlated’. The less correlated your investments are, the lesser the chance of them falling in value together.

Example: The correlation between frontier markets (Nigeria, UAE etc.) to emerging (China, Brazil etc.) and developed markets (US etc.) is relatively low, so frontier market investment can provide strong diversification benefits to an equity portfolio.

4. Gold is ‘negatively correlated’ to many mainstream asset classes

Gold has long been regarded as an ideal portfolio diversifier because it is historically among the most negatively correlated assets available to investors. In other words, in many instances it rises in value when other asset classes such as equities, bonds and property are falling.

Gold may help to stabilise portfolio returns even during periods of financial instability. In 2008, gold was among the few assets that produced a positive performance, yielding those investors who held it a gain of 2 per cent. During this same period, some major asset classes fell by more than 50 per cent. However, gold has fared less well since and in 2013 fell by almost 30 per cent.

5. Bonds and equities are considered polar opposites

Bonds and equities, held together in the same portfolio, make ideal portfolio diversifiers because they tend to move in opposite directions. This is the case because the market conditions that are good for equities tend to be less positive for bonds, and vice versa.

When investors make a periodic swing from equities to bonds, or the other way round, equities and bonds are said to be in ‘rotation’. How long such rotations will last is rarely predictable though, thus strengthening the case for having both equities and bonds in a portfolio.

6. Predicting an outperforming region or market is ‘more or less impossible’

In 2008, the worst year of the recent global financial crisis, US equities, as represented by the S&P 500 Index, registered a 37 per cent decline in value at year’s end. Only five years later, the same index produced a 32.39 per cent gain.

Likewise, emerging market equities, as represented by the MSCI Emerging Markets Index, posted a decline of 53.18 per cent in the 12 months to the end of December 2008, only to return 79 per cent during 2009.

While it could be argued that emerging market equities had nowhere to go but up after a 53 per cent fall, the main takeaway from our data of key asset class performance over the 10 years to the end of 2013 is that performance of all asset classes varies much more widely than most people expect.

This in turn shows yet again why diversification is so essential. Investment experts can suggest potential investment opportunities, but it is more or less impossible for anyone to predict which asset class or geographical area will deliver the best return each year.

7. Being a diversified investor means keeping your nerve

If your portfolio is well diversified, it will probably hold whatever asset class is currently performing well but also investments that are doing less well. For some investors, resisting the urge to unload the underachievers and buy more of the high performers can be difficult.

If you find yourself in this position, you may want to take a step back and think about considering a broad mix of return levels as evidence of the success of your diversification. If your top performing asset class suddenly falls heavily, you will be glad you had not switched all your investments to chase those higher returns.

It is worth remembering that a properly diversified portfolio is likely to generate a more stable and steady level of returns, with less steep swings in valuations or volatility, than if you put all your investment eggs in one basket.

Follow The National's Business section on Twitter