Diversification is a risk management technique that mitigates risk by allocating investments across different financial instruments, industries, and several other categories. The purpose of this technique is to maximize returns by investing in different areas that would yield higher and long term returns.
Most experienced investors agree that, although it does not provide any guarantee against loss, it is the most important component of achieving long-range financial goals while reducing risk.
In this article
- Diversification Across Different Asset Class
- What is Diversification in Mutual Funds?
- How Does Diversification Work in Mutual Funds?
- Stepwise Diversification Strategy
- Things to keep in mind before diversifying investments
- Why is Diversification Important for Investors?
- The Thin Line Between Diversification and Over Diversification
- On a Closing Note
Diversification Across Different Asset Class
Investors and fund managers usually diversify their investments across various asset classes and evaluate what portion of the portfolio to allocate to each. These classes can include:
Stock Market – Publicly traded company’s shares or equity
Bonds – government and corporate fixed-income debt instruments
Real estate and Properties – piece of land, buildings, natural resources, livestock, and water and mineral deposits
Exchange-traded funds (ETFs) – a collection of securities that follow an index, commodity, or sector and listed on exchanges
Commodities – Materials that are necessary for the manufacture of other products or services
Cash – Treasury bills, certificate of deposit (CD) and other short-term, low-risk investments
What is Diversification in Mutual Funds?
Mutual fund investment diversification means to diversify one’s investment into various types of mutual funds after doing a careful study of the personal investor and risk profile.
There are multiple options in mutual funds for investors. The broad categories are equity mutual funds, debt mutual funds and gold funds. These broad categories have their risk levels: equity is riskier than debt. Gold, at some level, carries the least risk of the lot.
Within the broad categories, there are subcategories again. For example, in equity mutual funds, large-cap funds are less risky than small and mid-cap funds. In debt funds, corporate bonds might be riskier than those who have more exposure to government securities.
How Does Diversification Work in Mutual Funds?
Like mentioned before, diversification requires investors to be aware of their risk appetite and life goals. The sole purpose of diversifying is to reduce risks in mutual fund investments. This, in turn, helps fetch higher yield returns on average. Thus, it manages to mitigate the impact of any one (or a few) low performing security in the overall portfolio. It might be a daunting task for a novice investor to actually implement the same in the portfolio. However, the overall concept is quite simple and can be implemented by considering certain parameters. In the next section, we have listed some of the strategies to follow while diversifying your portfolio.
Stepwise Diversification Strategy
The first step to understanding diversification is to define your risk appetite. Risk appetite is an investor’s appetite for how much money he or she can afford to lose. If an investor is psychologically well placed not to get very disturbed, seeing high scale variations in their investment during the short term, he or she may be a little high on the risk scale.
Not just psychologically, but one should also be able to afford short term fluctuations financially and have enough liquid money parked somewhere else to help you sail through such situations. This does not mean all investments have a high chance of running into losses. Losses are notional and on paper till investments are redeemed.
Match risk appetite with goals and investments
The second step involves sorting the risk element associated with various investment schemes. Different types of diversification come with different types of investors. For example, a risk-loving investor will diversify differently than a risk-averse investor. Now that you are aware of the risk appetite you have, you can sort it as per your goals by picking securities with diverse risk levels. This proves to be beneficial as even if you face loss in one, the profit from others can compensate for the that.
Building a Portfolio
As mentioned earlier, an investor must first build a portfolio including various investment instruments. This could be anything like options such as stocks and bonds, to cash mutual funds and other categories.
Pick from different industries
Diversification can also constitute of different industries. It might be hard to believe at first but everyone is interested in certain industries or sectors at the back of their mind. It is imperative to take into account and pick securities according to industries in order to mitigate the industry-specific risks.
Research about the fund manager
A successful diversified portfolio always has a major contribution to the skills of the fund manager. It is the manager who makes the decision of when and where to invest.
Things to keep in mind before diversifying investments
Risk: Assess risk appetite to know which asset class suits more. This has been exemplified in a detailed manner above.
Goals: If A has short term goals but has risk appetite and outs more money in equity, A might land into trouble because equity gives high returns only in the longer term. It is not ideal for short term investments. Therefore just knowing risk appetite is not enough; one needs to know when is the money required. In debt funds, there are liquid, ultra-short and short term debt funds that are meant for short term investments. One can make an informed decision if the goals and time horizon are adequately assessed.
Why is Diversification Important for Investors?
By now you must have gotten a clear picture that diversification is crucial and one of the most important principles in investing. If one wants to build a strong portfolio, it is of utmost importance to diversify their investments. Below, we have elucidated some of the benefits that diversification brings in for you:
- Diversifying obviously safeguards the various asset classes in your portfolio and helps it grow.
- One of the major benefits of diversification is as an investor, you get to learn about a plethora of investment choices and not limited to a few. You keep moving from just one form to another. This can make an investor well-versed with the market updates.
- Diversification educated investors about different investment strategies. Thus, by diversifying, one gets to explore multiple approaches to investing from value-focused to growth-focused investing.
- It brings down the overall risk of investing in a portfolio.
- Many investors are confined within the domestic market and don’t pay much heed to foreign portfolio investment. Diversification gives an opportunity to look beyond the national border when seeking investment options and thus opens the gate for international investment.
The Thin Line Between Diversification and Over Diversification
Over diversification takes place when an investor’s portfolio is overburdened with stocks or mutual funds where the marginal benefit of reduced risk is lower than the marginal loss of expected return.
Optimum diversification means that your portfolio should be large enough to eliminate risk but small enough to concentrate on the benefits.
Let’s look at a diversification example:
If A owned 500 stocks of different companies, he/she has reduced the risk, but at this stage, the portfolio may not have many high-performing stocks. There may come a day where A will end up in a no-profit-no-loss situation.
In the context of mutual funds, a fund that invests in more than 100 companies may not be the epitome of optimum diversification. At times this may make it difficult for the fund manager to get the ‘alpha’, meaning, to outperform the index. A new fund is suitable for your portfolio, but too many funds reduce the extent of gains an investor can get from having few but good funds in the portfolio. To conclude, large scale diversification may not make an investor lose much, but an investor may not gain a lot either.
On a Closing Note
Diversification can indeed help mitigate risk and reduce the volatility of an asset’s price movements. One should, however, keep in mind that no matter how diversified your portfolio is, complete elimination of the risk can never be possible.
For instance, you can go through individual stocks and reduce the risk associated with them but the market risks will affect every stock; hence diversify among different asset classes is equally important. The solution is to balance the risk and return.