Why Investors From India Should Diversify Their Portfolio
Over the last 10 years, India’s stock market has yielded great returns. It is one of the fastest growing equity markets in the world, outperforming even the S&P 500. Without accounting for the effects of inflation (for inflation adjusted return, read this), from August 2008 to August 2018, the S&P 500 index (GSPC) grew ~142%, while the BSE SENSEX grew 188%. Figure 1 illustrates the price trend between the two indexes over the past decade.
Figure 1: Five year return for SENSEX (BSESN) vs. S&P 500 (GSPC)
Despite the higher return, the SENSEX exhibits higher volatility. Volatility is an indicator of the riskiness of the investment. The higher the volatility, the more the price moves, the riskier the investment. One measure of volatility is the standard deviation of the return. In Figure 1 above, the SENSEX’s price trend is far more jagged than that of S&P 500. Figure 2 shows the one year rolling standard deviation of returns of both indexes for the same time period. It is evident that the SENSEX experiences more periods of higher volatility.
Figure 2: Volatility of Return comparison between SENSEX (BSESN) vs. S&P 500 (GSPC)
Volatility can be detrimental to the return of your investment. To illustrate, imagine you have $1 in your investment portfolio. If your investment goes up by 10%, the value becomes $1.1. If subsequently your investment decreases by 10%, the value becomes $0.99. Notice that even though your portfolio has increased and decreased by the same percentage, the absolute value has decreased to $0.99. If this is repeated many times overâ€Šâ€”â€Šthe return of your portfolio will suffer. As such, when constructing a portfolio, minimizing volatility can lead to a better and more efficient portfolio. This is the basis of the
Modern Portfolio Theory, where an investor chooses to maximize return for a given level of risk, and not take additional risk that will not yield additional returns.
The difference in volatility between the two markets can be explained by the difference in size. Compared to the Indian stock market, the US market is greater in size. In the US, 70% of the GDP is from the corporate sector, and 500 of these top corporations are represented in the S&P 500 index (market cap = US$ 23.7 trillion), making S&P 500 the standard bellwether to gauge the health of the US economy. In contrast, the Indian corporate sector only accounts for ~14% of the national GDP, and the BSE-SENSEX index (market cap = US$ 438 billion as of September 2017) only represents a very small fraction (30 companies) of India’s publicly traded companies, making SENSEX a small representation of the Indian economy.