Generally, we all diversify in our lives. Whether it is having food or buying clothes, shoes, or just a lipstick, we make sure we have a variety of different categories. Diversification is everywhere. Investing is no different. Portfolio diversification is an important principle in it. It leads to risk reduction and we discuss the same in this analysis.
In This Article
Portfolio diversification meaning
Portfolio diversification signifies investing your money in different asset classes to reduce the risk of the portfolio. Furthermore, if you invested all your money in one asset class, you can imagine the risks. As long as the stock performance is good, the investment is secure. Once the performance is bad, there will be huge losses. It is a bad investment idea to pursue in addition to being risky.
Consider as an illustration the example of your wallet. If you keep all your cash and cards in one wallet, it carries a risk. If you lose your wallet. Your cash and cards will be gone as well. Imagine a situation if you keep part of your cash in the wallet and the rest in a pouch in your briefcase. You will be able to save some money and rescue yourself.
Purpose of portfolio diversification
Undoubtedly, portfolio diversification has an important role in reducing your investment risk. It not only helps in spreading out the risks across multiple asset classes but also minimizes unsystematic risk in addition to the above. Unsystematic risk is subjective. It refers to a specific company or a market sector. Diversification aims to cut this risk. It will not have a greater impact on your investments.
It reduces the volatility of a portfolio. Not all stocks, assets move alike. Mixing a variety of asset classes almost reduces the unsystematic risk. Henceforth if you have a large number of investments in different companies and across industries, industry, and company-specific risk lessens. As a result, different assets will rise and fall as per the market situation. It will smoothen out the portfolio returns.
Diversification of non-related assets tends to lower the losses in bear markets. Subsequently, there is capital to invest in the bull market. Portfolio managers can invest a higher percentage of their assets in risk assets after calculating their total risk appetite through diversification.
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Pros of Portfolio diversification
- Market volatility shocks reduced: Diversification reduces overall risk to the portfolio. As investments are made in different asset classes, market volatility shocks reduce. Any exposure to a specific industry is reduced. Higher returns are generated.
- Portfolio monitoring time comes down: Diversified portfolio is stable in nature. If you have invested solely in equities, you will spend more time analyzing market performance. In contrast, if you have invested in low-risk mutual funds, you will be spending a lot of time finding ways to increase your returns.
- Compound interest benefit is offered: Investors are benefitted with compound interest in MF. They earn interest on the principal and accumulated interest over the years. As a result, there will be higher returns.
- Offers peace of mind to investors: This is primarily the biggest advantage. Risk is minimal as money invested across a variety of industries and asset classes. Therefore it ensures stable returns as the performance of the portfolio is not a worry.
- Keeps capital safe: Investors on the verge of retirement or those who have just began investing prefer to play it safe. Portfolio diversification ensures capital is safe as investments are made in different asset classes. This reduces the risk of loss.
- Optimal Funds: The funds are properly invested across different sectors. This stabilizes the returns as not all sectors move alike. Even if a few sectors perform badly it evens out.
- Capital appreciation: This helps to gradually appreciate the capital. Earnings accrued over time from a rise in certain sectors will boost portfolio performance. This capital can be reinvested into other schemes for greater returns.
Cons of Portfolio diversification
- Quality compromised: There are only a few companies that are a point of giving a margin of safety. The higher the diversification the lesser will be the quality of returns.
- Associated market risks: It is important to understand how portfolio volatility affects your portfolio performance. There are only a handful of investors who get average returns owing to market risk.
- Lack of attention: When someone else handles your portfolio, the chances of diluted attention to it increases. You might not be able to pick and choose the stocks on a regular basis.
How to Build a Diversified Portfolio?
1. Invest in a combination of MF or ETF: A combination of Mutual fund or Exchange-traded fund is preferred. 5/25 rule can be applied. Investors should select 5 different asset classes and not spend more than 25% of the money on them.
2. Use Bond funds: Fixed income funds guard your portfolio against volatility.
3. Keep track: It is not good to leave your investments on an auto-pilot. Pay attention to all the changes occurring in markets. Know when to get out and cut your losses.
4. Choose investments with different rates of returns: Always choose different investments with varying returns. This will provide substantial gains to your portfolio.
What is the relationship between diversification and portfolio risk?
In case your portfolio comprises just 1 stock, it will have risks of uncertainty at the market level and at the company level. Market risk is systematic and non-diversifiable whereas company-specific risk is diversifiable and non-systematic. If your portfolio is not diversified, it will have market risk and specific risk. If it is diversified, the total risk comprises of only market risk.
Do’s and don’ts of Portfolio Diversification
- Do your own research before investing: Firstly, make sure to read balance sheets and income statements of the companies you are planning to invest in.
- Never put all eggs in one basket: Secondly, you must diversifying your risks by investing across different asset classes and different sectors. It will even out your returns.
- Always keep a long term view: Thirdly, never try to time the market. The only logical solution is to stay invested and take a call keeping in view the long term.
- Invest consistently: Moreover, try to invest consistently. Maintain fiscal discipline. It will help you with rupee-cost averaging, which means your average cost of investing will come down.
- Take all costs into the calculation: Following this, add up the excess costs like statutory costs, exchange charges, Demat and related charges. It will give you a good picture. Opt for low-discount brokers who offer the same benefits.
- Adopt technology: Finally, comes online trading. It is the buzz word. It gives you ease and comfort to make your trades from anywhere.
Portfolio Diversification is vital in reducing your overall portfolio risks. It spreads out the risk across different sectors. Market risk and company risk hamper portfolios. Market risk is systematic and non-diversifiable while company risk is diversifiable and non-systematic. It is important to not over-diversify your portfolio. Investing regularly reduces the average cost of investing. One should follow the do’s and dont's before investing.
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