Portfolio diversification is an important step towards achieving your financial goals. Do you know the portfolio diversification formula? Read on.
What is Investment Diversification? How to diversify your portfolio?
Have you ever heard the saying about not putting all your eggs in one basket? Well, follow the same principle when it comes to investing.
Think about what would happen if you put all your money into one investment. As long as the stock continues to perform well, everything will be fine.
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But what if the market fluctuates sharply? You can lose your entire investment in a flash. And nobody wants that, right?
This is the reason why you should diversify your money into different types of investments to make your investment journey smoother. Thus, you will be protected from any single investment exposure. This will reduce your overall risk without reducing your returns.
It’s like you’re saying, “Since nobody knows who’s going to win this race, let’s bet on everybody.”
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What is Investment Diversification?
In simple terms, diversification is defined as having a diverse portfolio of investments that respond differently to the same market or economic event over time.
A diversified stock portfolio can include 20-30 (or more) different stocks in various industries, bonds, funds, real estate, gold, FDs and even mutual funds.
As the economy expands and contracts, each asset behaves differently and each has a different potential for gains and losses:
- Stocks – They have the best potential for long-term growth, but can fluctuate significantly in the short term.
- Bonds – They can provide more consistent income with fixed returns, but their value fluctuates as interest rates rise and fall.
- Funds – They are generally diversified as they hold different types of investments. Whether a fund is broadly or narrowly diversified depends on how it is managed.
- Real Estate – Being a source of income, it can grow steadily over time. However, maintaining physical real estate can be expensive and commissions are high.
- FDs and Savings Accounts – These will not increase in value, but will continuously increase in value over time based on interest rates or other contractual terms.
- Gold – It is advisable to diversify your portfolio with gold at least 5 – 15%. It is a safe investment, which acts as a hedge against inflation. It is a viable long-term investment.
- Chit Fund – Another place where you can invest your money to diversify your portfolio is chit fund.It is both an investment and a credit instrument. You can put in your surplus funds month on month for a fixed tenure and earn 10%-15% p.a. Furthermore, because it is a highly liquid instrument, it is a useful tool for raising funds in times of emergency. The Money Club is one such AI driven online chit fund platform.
By keeping a mix of stated investments when the market swings one way or the other, you reduce the risk of your portfolio taking a significant hit.
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Benefits Of Portfolio Diversification
Diversification has various benefits. This helps you get the right results you want, because assets perform differently in different financial periods.
Equities may fluctuate, bonds may be volatile, while gold and FDs may be moving slowly.
So in a way, investing in different amounts of each asset affects the weighted average of the returns of that asset.
Here are some other benefits of portfolio diversification that help reduce investment risk:
- It boosts your potential returns and stabilizes your results
- It reduces the impact of market volatility
- It reduces the time spent in monitoring the portfolio
- It helps in availing various investment instruments
- It helps in achieving long term investment plans
- It helps in taking advantage of compound interest
- It gives us peace of mind
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How To Diversify Your Portfolio?
Remember, Diversify is not a numbers game. The person with the biggest investment does not win the title.
Think of diversification like the act of building a cricket team. A team of good batsmen alone will not win you the game. To make a good team of 11 we need 5 batsmen, 4 bowlers, 1 all-rounder and 1 wicket keeper. So is your portfolio.
There are many strategies for diversifying your portfolio, but the basic principle is the same: Each item in your portfolio should serve a different purpose.
Here’s how to go about it:
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1. Research and plan before investing
Start by planning well by researching and planning to diversify your investment portfolio across the three major asset classes – cash, fixed income and equities.
What percentage of your total investment or portfolio should you invest in each asset class?
You will get your answer by considering your situation and investment preferences. Ask yourself:
- Why are you making this investment? What are your goals?
- How much time do you need to give to achieve your goal?
- What level of security is important to you when investing?
- What is your risk-taking capacity? Markets fluctuate in both directions. Do you lose sleep if your investments lose value when the market dips?
It is important to answer these questions before deciding what to invest in.
2. Spread the risk
If you put it all in shares of one company and it crashes, you lose all your money. If you invest it all in a single bond and the issuer goes bankrupt, you lose all your money. So, spread the risk. Diversify.
Diversification in such instances will reduce your risk by investing in different types of investments and types of investments. It does not guarantee profits or protect against losses, but it can help protect your portfolio.
3. Diversification of assets
A well-diversified portfolio combines several asset classes, or asset types, 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 upside potential. Bonds are less volatile than stocks, but their returns are lower.
Real estate is expensive and commissions are high Cash, FDs and gold are often considered the safest but have the lowest returns.
Under similar market conditions, each of these assets tends to behave differently. Diversification will balance your portfolio. Allocate a percentage of your portfolio to each asset class based on their risk tolerance, years to retirement and other considerations.
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4. Diversify across assets
Diversified your investments in different assets? Diversify again. Yes.
Let’s take the example of stocks. The diversification opportunities in stocks are endless. You can diversify by company size (large, mid or small cap stocks), region (Indian or foreign) and industry and sector. If you want to diversify your stock portfolio, but don’t have the time or motivation to do so, you can also consider mutual funds or exchange traded funds (ETFs).
The same is true of other assets like gold. You can invest in Physical Gold, Gold ETFs, SGBs, Digital Gold etc.
5. Know when to get out of it
Knowing when to exit your investments is also part of portfolio diversification. If the asset class you are investing in has not performed well for a long time, or the fundamental structure of the asset class has changed in a way that is not compatible with your objectives and risk tolerance, you should withdraw.
Remember, if you have invested in a market linked product, don’t exit just because there is some short-term volatility.
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Conclusion
Diversification is an important step towards achieving your financial goals. But there is no guarantee that it will not harm you.
Even after going through the whole process, you may lose your money. After all, there is no way to completely avoid risk. But it can definitely help you minimize the risk of market losses. Just make sure that your investment mix still aligns with your risk appetite and financial goals at least once a year.
Reassess your diversification approach when your financial situation changes. You can consult a financial advisor for advice and to keep track of your investments.
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