Most of us intuitively understand the concept and benefits of having a diversified portfolio – as we have heard “don’t put all the eggs in the same basket” umpteen times, if not more.
Temporal diversification is less well understood. Temporal diversification is building up assets in a particular asset category over a period of time.
An excellent portfolio of stocks may beat the market but may not give great returns in absolute terms if the market falls immediately after one has invested. Investing over a period of time will help hedge the risk of an unexpected crash in the market.
Let’s look at an example of investing in NIFTY:
- If one had invested all their money in NIFTY in 1990 and held on till 2014, their capital would have multiplied 22 times, this is about 13.3% return per year.
- If one had invested all their money in NIFTY in 2007 and held on till 2014, their capital would be just less than double its initial value, this is a return of just 8%. Reason for this low return is the market crash in 2008.
- If one had invested all their money in NIFTY in 2009 and held on till 2014, their capital would be a bit more than double its initial value, this is a return of 13.5%. Reason for this good return is the market crash in 2008.
- But if one had invested steadily over a 3 to 5 year period (any 3 to 5 year period from 1990), overall returns are much better.
- Another key thing we can glean form this is that investments made just after market crashes have given much better returns than in the boom years. This also means we need to be rational and look to buy when markets crash.
Temporal diversification may not be possible in some asset classes where a significant portion of the investment is done upfront. For instance purchasing real estate. But temporal diversification is possible if one is buying Equities, Gold etc as one can buy these assets over a period of time.
Ideally it is best to build up assets over one’s lifetime but we don’t live in an ideal world. If one has limited or no exposure to equities then building up an equity portfolio steadily over 3 to 5 year period will help minimize the risk through temporal diversification.
Temporal diversification enables consistency of returns this should be understood and leveraged.
So remember to not put all your eggs in at the same time.