Portfolio Diversification is a crucial step towards achieving your financial goals. But do you know the Portfolio diversification formula? Read on.
What is Diversification of Investment? How to Diversify Your Portfolio?
Have you ever heard the saying about not placing all your eggs in one basket? Well, follow the same principle when it comes to investments.
Think about what would happen if you put all of your money into a single investment. Everything will be okay as long as the stock continues to do well.
But what if the market makes a sharp shift? You could lose your entire investment in one fell swoop. And no one would want that, right?
That's the reason why you should diversify your money across a variety of investments to make your investing journey go more smoothly.
This way, you won't be exposed to any one investment. It will lower the overall risk without lowering your returns.
It is as if you're saying, "Since no one knows who will win this race, let's bet on everyone."
What is Diversification of Investment?
In simple words, Diversification is defined as having a diverse portfolio of investments that react differently to the same market or economic event over time.
A diverse stock portfolio might include 20-30 (or more) different stocks from various industries, bonds, funds, real estate, Gold, FDs and even savings accounts.
As an economy grows and shrinks, each asset behaves differently, and each has a varied potential for profit and loss:
- Stocks - They have the best potential for long-term growth, but they can fluctuate significantly over short periods of time.
- Bonds - They can provide more consistent income with fixed returns, but their value fluctuates as interest rates rise and fall.
- Funds - They are typically diversified since they contain a variety of investments. Depending on how a fund is managed, it might be broadly or narrowly diversified.
- Real estate - It can appreciate steadily over time while also being a source of income. However, maintaining physical real estate can be expensive, and commissions are high.
- FDs and Savings Accounts - They will not vary in value, but will continuously increase in value over time based on the interest rate or other contractual terms.
- Gold - It is advised to diversify at least 5 - 15% of your portfolio with Gold. It is a safe investment, acting as a hedge against inflation. It is a viable long term investment.
You lessen the risk of your portfolio taking a significant blow when markets swing one way or the other by holding a mix of the above mentioned investments.
Benefits of Portfolio Diversification
Diversification has various benefits. It smooths your results because assets perform differently in different economic times.
While equities may be zigzagging, bonds may be zagging, while Gold and FDs continue to expand gradually.
So in a way, owning varied amounts of each asset results in a weighted average of that assets' returns.
You won't get the stunningly high returns from owning just one rocket-ship stock, but you also won't have to deal with its ups and downs either.
Here are some other advantages of portfolio Diversification that help to reduce investment risk:
- It boosts your potential returns and stabilises your results
- It reduces the impact of market volatility
- It reduces the time spent monitoring the portfolio
- It assists in taking advantage of various investment instruments
- It assists in achieving long-term investment plans
- It assists in taking advantage of compounding interest
- It assists in keeping the capital safe
- It gives you peace of mind
How to Diversify Your Portfolio?
Remember, Diversification is not a numbers game. The person with the largest investments does not always win the title.
Think about Diversification as building a cricket team. A team of only good batsmen won't do you much good in a game.
To have a well-rounded team of 11, you need 5 batsmen, 4 bowlers, 1 all-rounder and 1 wicket-keeper. Likewise with your portfolio.
There are numerous strategies to diversify your portfolio, but the basic principle remains the same: each item in your portfolio should serve a distinct purpose.
Here's how to go about it:
- Research and Plan well before Investing
Begin by researching and planning well about diversifying your investment portfolio throughout the three major asset classes: cash, fixed income, and equities.
What percentage of your entire investments, or portfolio, should you put into each asset class?
You will get your answer by considering your circumstances and investment preferences. Ask yourself:
- Why are you making this investment? What are your objectives?
- How much time do you have to achieve your goals?
- What level of security is crucial to you when investing?
- What is your risk-taking capacity? Markets fluctuate in both directions. Will you lose sleep if the value of your investments drops when the market falls?
Before deciding what to invest in, it's critical to answer these questions.
- Spread the risk
You'd lose all of your money if you put it all into one company's shares and it crashes. You'd lose all of your money if you invested all of it into a single bond and the issuer went bankrupt. Hence, spread the risk. Diversify.
Diversification will reduce your risk in such instances by investing in a variety of different investments and types of investments.
It does not guarantee profits or guard against losses, but it can aid in the protection of your portfolio.
- Diversity across assets
A well-diversified portfolio combines many asset classes, or types of assets, with varying levels of risk. Stocks, bonds, cash, real estate, FDs and Gold are some of the options to include in your portfolio.
Stocks are the riskiest of them all, but they also have the biggest growth potential. Bonds are less volatile than stocks, but their returns are lower.
Real estate is expensive and the commission is high Cash, FDs and Gold are often thought to be the safest but have the lowest returns.
Under similar market conditions, each of these assets tend to behave differently. Diversification will balance your portfolio.
Allocate a percentage of your portfolio to each asset class based on their risk tolerance, number of years till retirement, and other considerations.
- Diversify within assets
Diversified your investment among different assets? Diversify again. Yes.
Let's take stocks for an example. The opportunities for diversification in stocks are endless. You can diversify by company size (large, medium, or small-cap stocks), region (indian or foreign), and industry and sector.
You can also consider mutual funds or exchange-traded funds (ETFs) if you want to diversify your stock portfolio but don't have the time or motivation to do so.
Same goes for other assets like Gold. You can invest in Physical Gold, Gold ETFs, SGBs, Digital Gold and so on.
- Know When Should You Leave
Knowing when to exit your investments is also a part of portfolio diversification. If the asset class in which you've been investing hasn't done well for a long time, or if the fundamental structure of the asset class has changed in a way that doesn't align with your objectives and risk tolerance, you should withdraw.
Remember, if you've invested in a market-linked product, don't get out just because there's some short-term volatility.
Diversification is a crucial step towards achieving your financial objectives. But it doesn't guarantee that you will not suffer losses.
It is still possible to lose your money after going through the entire process.
After all, there is no way to totally avoid danger. But it can definitely help you reduce the risk of market losses to the bare minimum.
Just make sure your investment mix is still aligned with your risk appetite and financial goals at least once a year.
Re-visit your diversification approach when your financial circumstances change. You can even consult a financial advisor to take advice and keep a track of your investments.