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The Dynamics Of Diversification

Ever Wondered Why Equity Corrects When Interest Rates Rise Or Why Gold Prices Rise When Stock Markets Fall?

Various markets are intertwined. Normally, when the interest on fixed income instruments goes up, the equity market is down. Similarly, when the equity market is down, gold is up. An example should explain why this happens.

Assume company A has equity capital and debt of `100 crore each. Its earnings before interest and tax is `20 crore. The interest on borrowings is 10 per cent a year. The earnings after interest and before tax will be `10 crore. Assume the interest on borrowing goes up from 10 per cent to 12 per cent.

The earnings after interest and before tax will go down to `8crore. Thus, in a rising interest rate scenario, the bottom line of companies fall. Similarly, in a falling interest rate scenario, the bottomline grows. As a result, the share price moves up due to better valuation when the interest rate moves down and goes down when interest rates go up.

The changes in rates affect the value of companies and their shares. This is because; a company's share market value is its projected future cash flows, discounted to the present, using the investor's required rate of return.

If interest rates fall and everything else is held constant, the share value should rise. That's why the market cheers when the Reserve Bank announces a rate cut. Conversely, if the RBI raises rates (holding everything else constant), share values fall.

Another reason for the inverse relationship is that more money will be diverted to fixed income instruments when interest rates are moving up, which affects To look at the correlation between the Nifty, the gold price and interest rates, we have tabulated the values of the S&P CNX Nifty, Gold BeES (Gold Benchmark Exchange-Traded Scheme) and State Bank of India's deposit rate for a one-year deposit.

A look at the historic data brings out the variation in the movement of the S&P CNX Nifty values, gold prices and interest rates. We assessed the relationship between the three at the end of every year from March 31, 2007, till date.

As can be seen from the table, the value of the S&P CNX Nifty, Gold BeES and interest rates moved up in 2007-2008 due to bullish sentiments in all markets. In 20082009, the Nifty value was down by 36 per cent, whereas Gold BeES was up by 24 per cent, showing the inverse relationship in the two markets. The interest rate were more or less stable during the period. In 2009-2010, the Nifty value was up Building a suitous classes of assets like debt, equity, real estate, gold and so on. Even From the example, it can be seen that the investor who invested in equities in March 2009 is reaping a bumper windfall even now. Similarly, in a four-year period, gold has doubled its value, whereas the S&P CNX Nifty has increased by only about 50 per cent. Putting money in a fixed income instrument enables you to have an assured fixed income, safety of capital and at times earn better returns when the rates are high.

The idea behind diversification is primarily to ensure the different assets in one's portfolio do not move in the identical direction at all times. If so, there would be no hedge against losses.

TAKEAWAYS

Various markets are intertwined and affect each other

Normally, when the interest on fixed income instruments goes up, the equity market is down

When the equity market is down, gold prices are up

Diversification helps to tide over imbalances of various markets

Investors need to diversify across sub-classes of a particular asset class

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