When people talk about diversification, normally it is from returns perspective. But, at the core of it is managing risk. We diversify because we want to make sure that price fluctuation in individual asset should not impact the overall portfolio. A perfectly diversified portfolio is one where we have inversely correlated assets, i.e. price of one asset grows if other falls and vice versa and on an average level in long term, we manage to generate good return at portfolio level, while managing the risk.

Portfolio Basics and the Need for Diversification

The concept of diversification applies even at single asset class category level too, like Equity. So, if you want to buy some stocks like a Fund Manager, there is a portfolio of stocks which needs to be constructed to ensure that the Equity portfolio is well diversified and we are able to get benefit of different businesses while also mitigating business risk. We will discuss Equity portfolio sometime else. For now, we focus on a wider portfolio consisting of different asset classes.

As you know, there are various asset classes. Typically, investors classify an asset based on its risk category. Risk is directly proportional to returns and hence the returns generated from the asset also depends on amount of risk.

There are different views on definition of risk. For the sake of simplicity, we will define volatility as risk. For example, if an asset price changes by 5-10% every day, it may be called risky because potentially one may make losses in such an asset. If another asset grows at a consistent pace and never falls, it is the least risk or zero risk because potentially there is never a loss. The risk of volatility can also be associated with liquidity or mismatch of demand/supply. When there is huge demand and not enough supply, you would see an asset price rise exponentially. Like, we see in bitcoin for example. Due to volatility, one may call it risky.

To summarize, we want to diversify to have risk adjusted returns which makes the entire portfolio grow consistently while managing risk at individual asset level.

Asset classes and the Risks associated

Lets look at different assets classified broadly based on risk for a diversified portfolio. The risk itself may be caused due to liquidity, credit default, market, business, macros and many other factors.

1. Fixed Rate Assets:

These are fixed income assets where the price appreciation is pre-decided. For example, Bank FDs, Government Bonds, Liquid funds etc. The important thing to understand here is Interest rate. You can understand Interest rate as the fixed price you get for sacrificing your present cash in hand. Money used today is always costlier than used tomorrow. If one wants to borrow it from me, I would demand an interest because I am sacrificing my present. Investors rent money today to gain interest for tomorrow.

Banks give away money as a loan to business as debt and in return, earn interest. As an investor, we deposit money in bank to earn interest. This is normally at a fixed rate based on the dynamics of a country and the central bank. Broadly, the rate is determined by inflation. That explains, why interest rates differ from one country to another.

This is an asset class with almost zero risk. I use the word ‘almost’ because there is always a risk of default in this class. We take sovereign guarantee as a word from God and believe, it will never default. But, we have seen banks default in the past and it can always happen. So, there is a minor risk which you take and that gets added to your return. Banks borrow money from RBI at certain rate and make profit on it. They also borrow from investors and pay them 1-2% higher return. This takes into account inflation and default risk. In Indian context, this returns range from 7-11% depending on the default risk involved.

If you lend it to some unsecured category individual, as some apps like Cred allow, you may get a little higher return. Some Corporate Funds may give you 11-12% return because of the extra risk taken.
Always remember, returns never come without risk. So, if you are getting 1-2% higher, remember the risk you are taking. Never buy the story of risk free return in a fixed income product unless it is a Bank FD or Government bonds. As the famous quote goes, ”In God we trust. All others must bring data.”

2. Gold

This is India’s favorite asset class. Everyone loves the yellow metal and tell stories of high returns it has given. Gold is an asset equivalent to Dollar and you can call it a global currency. Of course, there is a price change due to demand/supply. Normally, this is used by all central Governments to increase foreign reserve and there is always demand/supply mismatch for fixed amount of gold available on earth. Whenever there is a mismatch in demand/supply and there is depreciation of buying power of some currency, the gold price will appreciate. In Indian context, whenever you will see depreciation in value of rupee v/s dollar, gold prices will appreciate. Globally Gold price will appreciate depending on global demand and supply.

Based on the data available by Forbes India for past 25 years, Gold has grown at 11-12% per annum in rupee terms and has been a consistent compounder, helping individuals beat inflation largely and achieve returns better than Fixed income category. There is no liquidity risk in Gold as such since there is enough buying and selling options available. An investor can buy Gold in Physical or digital form via Mutual Funds. Government of India has discontinued fresh selling of Sovereign Gold bond. SGB was a good wealth creator for many in recent years because of it being a combination of asset price appreciation and also regular income. Some amount of Gold in your portfolio is good to keep it shining.

3. Real Estate

Land is another asset available to the world in limited quantity. The price appreciation here depends on demand supply and it is always a local phenomenon. For example, price appreciation in Pune may not be same as Indore, purely in percentage terms. Broadly, this also fits into 10-12% returns to an investor in very long term after taking different expenses into account. The real estate returns are tied to liquidity risk. The biggest risk for an investor is not being able to sell when you want. So, many would classify this as a ‘Use Asset’ for people and not really an investment because you simply buy a house and live there, effectively saving on the growing rental cost.

An individual should consider this as an asset in the diversified portfolio, purely from housing point of view. Getting return etc. will need solid knowledge of property and hence risky. Normal investors should stay away from investing in Real estate as commodity unless there is sufficient knowledge and liquid cash available.

4. Stocks or Equity for a Diversified Portfolio

A misunderstood Asset Class

Equity is a popular asset class with investors. The fact that you can check prices real time makes it an emotionally taxing asset. It requires some amount of financial literacy to make sense of value and price of underlying Assets. Financial world has always kept this as an enigma and the knowledge isn’t much democratized in this space.

Mostly investors just view it from the lens of prices. Business value is always volatile and hence considered risky. An individual should never consider owning stocks directly if they do not understand or do not have the bandwidth to understand.

Fundamentally, one must understand that the underlying asset in a stock price is a Corporate body. So, if you do not know the details of the business, you are taking a risk just based on price and it is not much different from betting in a casino. There are good fund Managers running Mutual Funds to help you own the stocks. An investor with limited bandwidth to understand business must go via Mutual funds and participate in wealth creation journey. This asset class fundamentally can generate much higher return than any other asset because of disproportionate risk involved in the assets.

Business risk and the risk Premium

The biggest risk in Equity is of business. Businesses do go bust, you know. So, the stock prices may come down to zero in such a case. As an investor, if I am taking that kind of risk, the returns expectation also should be higher. So, there is no reason for us to settle at low 10-12% range of returns in long term.

Most of the wealth creation around us is via business only. Either you create a business or own a business created by someone else. The success or failure of the business will depend on macro factors like state of economy, interest rates etc. But, the rewards are always going to be high. Several good Fund Managers have generated 15-20% and higher returns in long term. The key to success here is to think like a business owner and stay invested for a very long time.

Balancing Stocks, Bonds, and Other Assets – How to get a Diversified Portfolio

Now, that we understand the need for diversified portfolio, various asset classes available, lets understand how to diversify.

Debt Funds for Emergency Funds

A smart investor would keep fixed rate investment for emergency funds. Rest of the asset classes if you notice have liquidity risk, i.e. you may not find a buyer when you are in need of money immediately. This is where fixed rate investments are useful if they come with liquidity. PPF/EPF are not liquid assets due to long term lock-in. For emergency funds, one can consider Liquid Funds/FDs/Savings account. Typically, one should have at least 6 months of expense set aside as emergency fund. You may look for Debt-based Mutual Funds/Bank/Post Office or any other mechanism to park your money safely to withdraw on demand.

Liquid funds are not investment. They are just your risk mitigation plan. Do not look at generating high returns there at the cost of locking them up. Anything in the range of 6-8% is good enough. The main purpose here is not to grow money, but to mitigate risk of emergency.

PPF and Government Bonds

Once we have sufficient Emergency Funds, should you own PPF/Government bonds etc.? Once we have sufficient Emergency Funds, we can park money to generate higher risk-adjusted returns. Depending on your risk profile and understanding of asset, one should take risk. Remember, returns are proportionate to risk. So, no risk would also mean no return and hence inability to beat the inflation.

Debt Funds to Manage Risk

Asset allocation is never a straight approach and has diverse views. Broadly for <35 Age category, any money not needed in next 2 years can be exposed to higher risk to generate better returns. For older individuals, nature of job, dependents, short or mid-term goals will decide the risk profile. Allocate funds for near and mid-term goals. But, broadly an investor should look at generating highest possible risk-adjusted returns out of the funds available after we have taken care of Emergency needs and short to mid-term goals.

There is no rule of thumb here and one must get a risk profiling done to understand the level of diversification needed. Sometimes, there are short or medium term goals which need a different asset class. There are many who would suggest Balanced fund or 30:70 ratio for debt to equity ratio. But, it all depends on your risk profile and goal. A Financial Adviser can analyze your financial position in order to create a balanced portfolio of assets.

Adjusting Portfolio Based on Goals

A portfolio needs periodic review depending on market conditions. You will need to adjust the portfolio based on change in immediate goals or change in market conditions. For example, there are years when Equity may not give the expected level of return and optimizing the portfolio by switching some funds to debt or Gold may generate better returns. Multi-Asset Mutual Funds take care of this balancing and is good for peaceful investing technique. Alternatively, an individual can do this exercise. It is not easy to time the markets though and it needs expertise. So, it is advisable to go via Mutual Funds.

Final Thoughts on Diversified Portfolio

A diversified portfolio is key to peaceful investing. An ideal portfolio is where you don’t lose a night’s sleep. Money management should come with peace. Diversification is also a way to achieve peace because it ensures stability irrespective of market conditions. Look at different asset classes and based on your risk profile, allocate sufficient funds in each category. The portfolio needs adjustment based on goals. A Financial Adviser can guide you through the process. It is perfectly fine to manage it on your own if you are equipped with right knowledge. In this internet age, overflow of knowledge can make you confused and you end up making wrong decisions. Hence, consulting an financial expert is always good to ensure you are making a right choice.

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We learned about moonlighting, where companies complained about employees holding multiple jobs simultaneously. A notable incident was when Wipro fired 300 employees for moonlighting, bringing the issue to the forefront, with many other companies following suit.

Then came the concept of quiet quitting, where employees disengaged from their roles without formally resigning, choosing to hang around until they were eventually let go. While quiet firing—where employers subtly force employees out—has long existed, quiet quitting was a newer trend.

We also encountered the term The Great Resignation. Many employees, prioritizing life over work, began resigning in pursuit of better career opportunities or better work-life balance. This shift caused quite a stir in HR circles, as the cost of hiring new talent is substantial.

COVID also brought a shift in perspective. People began to value life and sought to balance it with work. Businesses, in turn, realized that remote work was a feasible option and that employees didn’t always need to endure the daily grind of commuting to the office. The transactional nature of the employee-employer relationship became more evident. For HR professionals, maintaining trust and engagement in this new landscape became a significant challenge. Remote work made employee engagement even harder, leading to a gradual push toward a Return to Office (RTO). Employees who embraced the freedom of working from home may find this transition challenging, but many will need to adapt to the new realities. In response, employers are now striving to provide greater work-life balance than they did before the pandemic.

From an employer’s perspective, the relationship with employees has always been somewhat transactional. However, it’s the employees who, for the first time, truly embraced the concept of work-life balance, realizing that their careers didn’t need to dominate their lives. The pandemic gave people a new outlook, particularly younger professionals who now tend to be more demanding than their seniors. The older generation often found themselves more emotionally and financially dependent on their employers, making them less likely to push back.

All about Financial Independence, Retire Early (FIRE)

With this backdrop, let’s delve into the latest buzzword to emerge post-COVID: FIRE, which stands for “Financial Independence, Retire Early.” This concept embodies two main ideas: 1) Achieving Financial Independence and 2) Retiring early.

Let’s explore these ideas further.

Financial Independence:

The term independence is inherently tied to its opposite—dependence. We can only understand independence in the context of financial dependence. Early in your career, the primary goal is to earn enough to meet your financial needs. Financial independence becomes meaningful when you realize the freedom it offers from depending on a steady paycheck to cover basic expenses. The definition of basic expenses gets subjective from here on. As you grow in life, you tend to expand the basic expense definition. Many new things get added to this as you grow. This can be easily explained using Maslow’s hierarchy of needs.

Physiological needs are at the base of the pyramid of needs like food and shelter. Fulfilling the remaining needs beyond this level leads to greater happiness. While a house may be considered under Safety and Security, some may argue it falls under physiological needs. The focus here is on the fact that individuals strive to meet most of these needs during their lifetime, with only a few reaching ‘Self Actualization’.

We should learn to make a distinction between needs and desires. Once physiological needs are satisfied, the emphasis shifts to psychological well-being.

It is important to recognize that you are a product of your surroundings, regardless of how you perceive yourself and what you think, defines you. Once you understand this, it will give you a better understanding of root of your desires. For example, if you have friends who love to travel, chances are you will desire to travel. If your friends/family enjoy food, chances are you will be a foodie. The desires are really an outcome of your surroundings and fundamentally there is nothing that ‘Defines’ you. This is difficult to understand because you have always believed that there are certain aspects that define you and you are unwilling to change what defines you. Pay close attention to your habits, likes, desires and you will realize this is all an outcome of your surroundings. If you change your surroundings, your desires will change too.

This may sound defeatist to many, but the reality is that in one life time nobody can fulfil all their desires because there are no limit to desires, which are shaped by people around you. Once you stop internalizing the external factors, you succeed in defining boundaries to your desires. Unless this is done, there will never be ‘Financial Independence’.

Achieving financial independence occurs when our current assets can cover our future expenses to meet our needs. Many individuals lose sight of their initial motivation for entering the workforce, which is typically driven by financial dependence. People work to generate a steady income to meet their needs. As these needs are fulfilled, attention turns to fulfilling wants, which is optional. By prioritizing financial independence above everything else, one can focus on building assets to secure future financial stability. This approach helps avoid perpetual reliance on a job and ensures financial independence.

To summarize, Financial Independence is a state where an individual has built assets which can take care of their future cash flow to fulfil their needs. Once this state is achieved, you are not working for money any more. This is when you may get the ability to start your journey to the final stage in Maslow’s hierarchy of needs, i.e. ‘Self Actualization’.

Retire Early:

Lets look at the next stage of being Financially Independent. Once you have reached the stage when you can call yourself ‘Financially Independent’, you can choose to retire early. The retirement does not mean you stop working. You can continue to work, but you don’t work for money any more. Imagine the independence in your thoughts, once you know you do not have to work for money alone.

Many confuse retire early with getting out of work early. Retirement doesn’t mean not working, all it means is not having to work for money alone. Financial Independence early in your life will give back the time which you were renting so far to get the cash flow. You can focus on getting back your time to do things which are more meaningful to you.

I hear from people, what do I do if not work? This is a side effect of Industrial Revolution. It has converted Humans into efficient robots and made them believe that their only purpose in this world is to work for money. In fact, people do not appreciate the power of ‘Not doing anything’ enough. The thought of ‘doing nothing’ scares many because they never looked at it this way. As I said earlier, your desires are shaped by your surroundings, so is your need to do something. A majority has agreed to normalize ‘doing’ and their definition of ‘doing’ is to do something for Money.

Financial independence opens up a world of possibilities beyond the traditional notion of retirement. It allows individuals to redefine their relationship with work and money, emphasizing personal fulfillment and meaningful pursuits. By breaking free from the cycle of working solely for income, one can explore new passions, engage in creative endeavors, contribute to causes they are passionate about, or simply enjoy the freedom of time. The concept of early retirement, in this context, is not about idleness or escaping responsibility. Instead, it represents a shift towards a more purposeful and intentional way of living. It challenges the societal norms that equate productivity with worth and encourages individuals to prioritize their well-being and happiness above all else. Embracing the idea of ‘not doing anything’ as a valuable and enriching experience can lead to a deeper appreciation for the moments of stillness, reflection, and self-discovery that are often overlooked in a society driven by constant activity and productivity. Ultimately, achieving financial independence early in life is not just about reaching a financial milestone; it is about reclaiming your time and autonomy to live a life that aligns with your values and aspirations. It offers the opportunity to break free from the constraints of a money-driven existence and to pursue a more fulfilling and balanced lifestyle that prioritizes personal growth, relationships, and overall well-being.

Conclusion

After joining the workforce due to financial dependence, one must aspire to reach Financial Independence by creating assets which can take care of future cash flows. Once Financial Independence is attained (not an easy job), try to identify something that gives you more meaning and helps you utilize your time more efficiently to fulfil your dreams. It could be travel, reading, learning, anything that you would have wanted to do with your time, go ahead and do that. Work very hard to achieve Financial Independence early in life so that you can enjoy it in your prime instead of letting the external factors decide when you can get back your time. What is stopping you from taking back the control of your life?

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