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Worried about market volatility? Portfolio diversification may help generate better risk-adjusted

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In an uncertain and volatile environment, betting on a sector or set of stocks that will be favourably impacted if certain macro events play out can be a risky strategy.

By George Heber Joseph

Markets hate uncertainty and hence in an uncertain macro environment, market volatility increases. In an uncertain market environment, how factors such as interest rates, liquidity, inflation, commodity prices etc. move is more difficult to predict. Geopolitical events add another dimension to these uncertainties. Many a time, decisions in geopolitical context are not necessarily based on purely economic considerations. This makes it even more difficult to predict the turn of events.  

Equity markets comprise of diverse sectors. A particular macro factor would impact some sectors favourably while other sectors may be adversely affected. Eg an environment of rising commodity prices favours commodity producers while commodity consuming sectors are adversely affected. Similarly, in an easy liquidity environment, companies which are growing fast but have with weaker cash generation and balance sheet also can outperform, whereas in a tighter liquidity environment market participants shift focus to cash flow generation and balance sheet strength. 

In an uncertain and volatile environment, betting on a sector or set of stocks that will be favourably impacted if certain macro events play out can be a risky strategy. What makes this risky is that more often than not, such macro factors are binary in nature. So, either your prediction comes true or a totally different outcome occurs. Thus, you can make handsome profits if macro plays out favourably. But if macro direction is adverse, portfolio can run losses for significant period. Hence running a diversified portfolio and focusing on stock selection within sectors would give better risk adjusted returns.

Predicting the direction of macro factors or events is not easy even for macro-economic specialists. Even large organisations such as IMF, World Bank, Central banks across the world have seen their forecasts go significantly wrong. In all major crisis, such as Asian financial crisis,  the housing bubble in 2007, euro crisis on 2011, or the commodity bust of 2022 to 2016, final outcomes were far severe than what experts predicted initially. 

Equity managers normally specialise in company-specific micro research. They are not normally macro-economic specialists.  Hence those equity investors who run a reasonably diversified portfolio and focus on bottom-up stock research, have been able to provide superior risk-adjusted returns. 

Even over the longer term, investors running diversified portfolios, give better risk-adjusted and more consistent returns. Focus on quality of business (Q) and buying stocks with a good margin of safety (S) is important in equity investments. This is because, by the time, macro developments become very clear, prices of stocks benefitting from those events have already run up. Eg in 2017, mid and small-cap stocks and NBFCs were the favourites and IT sector was totally neglected by markets. In 2018, IT sector generated handsome returns even as mid and small-cap stocks suffered losses. Thus, focusing on margin of safety (S), quality of business (Q) gives better returns over longer term. 

These two factors along with Low Leverage (L) form the core of our SQL equity investment philosophy.

(George Heber Joseph is the CEO & CIO of ITI Mutual Fund. Views expressed are the author’s own. Please consult your financial advisor before investing.)

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