Have you ever wondered why your neighborhood grocery shop or departmental store keeps a wide range of products belonging to different categories of toiletries, bakery items, and food items? Well, you got it right because he doesn’t want to lose any customer.
He plans to minimize his overall “risk” of losing business or profits. This is what is required when you invest your money in achieving your financial goals.
You are advised not to invest your whole life in only hope or single asset, you better “Diversify”!
In this article
What is Diversification?
Considered as one of the basic principles for a solid portfolio performance, diversification means keeping a complete assortment of assets from available broad categories like stocks bond and cash.
The rationale behind doing so is to get into risk-management technique, build a mix of a variety of investments to create a portfolio which has superior performance.
Also termed as “Asset Allocation”, financial advisors segregate and allocate investment across various financial instruments like shares, equities or bonds, sectors, and boundaries.
The aim of diversification is not just to reduce the risk but also to maximize the returns. Diversification can at the same time lower the impact of market volatility.
In short, asset allocation is breaking your investment portfolio among various asset classes, evaluate or decide the mix of assets based on your financial goals (Unique to you), keep a balance between risk and returns acceptable to you and performing all this within your time horizons.
Say for example you invest all your funds in a single stock and the value of the stock fall by 50%. You lose 50% of your portfolio.
On the other hand, if you invest the same fund in three different stocks and two separate mutual funds, the chances of losing so heavily are reduced or eliminated.
Even in case of one stock going down by 50%, you can make-up the loss from another asset you have invested in.
The question- Why diversification can be answered with the following rationale:
- Markets are unpredictable: To predict the market movements is not possible. The volatility of market can impact portfolio performance. You cannot precisely chalk-out best-performing investment instrument, especially in short-term. Therefore, spreading investments across various assets will spread the risk.
- You always have a cushion: When diversifying, you still have some assets which will leave you with good returns. Hence, in cases of economic downturns, market slowdown, global recession, or domestic recession you keep a balance and reduce the losses.
- Explore beyond home grounds: When you diversify you come out of “home country bias”. As an investor who is lured to only domestic markets, you start focusing on various other sectors, industries, and even global markets. You come out of your comfort zones, and hence reduce the possibilities of loss due to domestic, global or industry slowdowns.
- Awaiting opportunities: Diversification opens up thousands of possibilities. You delimit yourself and your portfolio to earn those extra dollars. Though diversification exposes you to increased risks, at the same time, it elevates your earning potentials.
Points to Keep in Mind While Diversifying
There are various ways you can diversify while investing, but you must keep the following in mind:
- Mix minimum: You must have a minimum mix of three different asset classes namely- stocks, bonds, and cash. If you can strategize yourself keeping in mind the goals and time it is the best, or you must consult some financial expert while planning the mix.
- Keep it simple: The diversification should be kept simple and precise like investing in low-cost index funds.
- Be aware of fees: While investing in mutual funds or index funds, you need to pay fees or expense ratio. Keep track of all such fees so that you don’t land up miscalculating the earnings. You must completely research on this subject as the lower the fee, the higher is the investment, and returns are accordingly.
Your Capital Must be Divided into
- Growth assets: They provide long-term capital gains and include investments like-shares or property. Keep in mind that growth assets have high risks and hence must be weighed against your risk tolerance.
- Defensive assets: Usually they provide lower returns on long-term but are lower in risks. They include cash or fixed interest.
- Within asset class: Try diversifying within the same asset class like investing across different industry sectors.
- Domestic stocks: Considered the most aggressive part of your portfolio, they deliver higher growth over the long term, but also hold the highest risks.
- Bonds: You must invest in bonds as they provide cushioning from the unpredictable highs and lows of stocks. They deliver regular interest income and reduced risk factor.
- Multiple fund managers: While diversifying try to invest with more than one fund manager. When doing so, you will take different approaches to investing and hence greater chances of maximizing your returns.
The Disadvantages of not Diversifying
Investors usually face two kinds of risk when investing- Systematic risk and Unsystematic risk. While the former is caused due to inflation rates, political instability, sudden natural hazards or war, the later is due to specific company performance, industry changes, market conditions, or economy.
Systematic risks are beyond control, but unsystematic risks are controllable by diversification. As the common sources of unsystematic risk are financial and business risk you must perform diversification and reap the benefits and control the risks.
Advantages of Diversification
The following are the advantages of diversification:
- Reduce the risk: Concentrating all your investment exposes you to complete risk. However, allocating the same fund in various assets can deliver better returns with reduced potential losses.
- Keeping Capital intact: Investors who don’t have age on their sides can always benefit from diversification as their lower risk tolerance is taken care while doing so.
- Assurance of returns: Investing only in one asset may not give you dividends, as performance is not predictable. However, when with multiple assets you reduce the chances and get the assurance of returns.
Every coin has two sides, like-wise with so many benefits of diversification comes to the catch. Diversification may diminish your portfolio’s overall growth. The same can be understood by an example.
Say, you invested in single stock, and it rose by 20%. Your entire portfolio grew by 20%. Hence, if you have invested Rs.100, 000/- you earn Rs.20, 000/-.
However, if the same amount when diversified into, say 50% each in stocks and cash, will earn you Rs.10, 000/- only (keeping in mind that there were no change in cash value). Your overall earning is lessened in this case.
Now you need to evaluate the earning and the risk tolerance while selecting the diversification mode.
No doubt that research also supports that 88% portfolio performance depends on asset allocation.
To lessen the potential losses by investing your capital in a single asset, it is critical to diversify and invest in a variety of asset classes. While diversifying you select different investment styles, over the same period, and generate different performance results.
This way you operate funds differently and further decrease the overall volatility of your portfolio.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.