Diversifying your investments is important to help reduce the risks faced by your portfolio. Therefore, it is critical that you understand the concept of diversification before acting on it.
Every financial expert says diversification reduces risk. But, not many understand what diversification is. One definition of diversification goes like this:
A portfolio strategy designed to reduce exposure to risk by combining a variety of Investments, which are not likely to move in the same direction at the same time.
Ideally, you would want to own different types of investments such that your investment portfolio (as a set of investments) does well. Today, some investments may do well while others may not, but the very opposite could be true tomorrow. So, if you have an assortment of investments in your portfolio, it is very likely you’ll always have something that is performing relatively well.
Additional Reading: 5 Golden Rules Of Investing
Benefits Of Diversification
Owning various kinds of investments can help decrease the volatility that your portfolio is likely to face over the long term. Volatility refers to the ups and downs that your investments go through. Even though people like to think that good investments always keep moving up, the truth is that the so-called good investments go down at some point in time or another.
Let’s take a look at how diversification reduces volatility. Let’s say that you buy a Mutual Fund that owns stocks that tend to do well when the economy does well. If you hold only that fund, your returns wouldn’t look great if there is a recession.
So, in order to diversify, you go about finding a fund that invests heavily in pharma and food stocks, which generally do well during recessions. By owning the second fund, you limit your losses when the economy doesn’t do well. That’s how diversification helps you.
The same is true for stocks. Owning stocks from only one sector or industry will increase the risk your portfolio faces. For example, if you own only Information Technology (IT) stocks, and if the rupee appreciates against other currencies such as the dollar, this appreciation could hit your returns. This is because IT companies receive large revenue from abroad.
But, if you own stocks from the engineering or aviation sector, which imports machinery or raw materials from abroad, the rupee appreciation may have a positive impact. The positive offsets the negative through diversification.
Additional Reading: Diversify Your Portfolio With Style
It is not only important to know what diversification is, but it is also important to know what diversification isn’t. Keep the following important points in mind:
- Don’t think that if you diversify you will never lose money. Diversification helps reduce your losses but does not completely prevent them.
- Diversification is ideal for the long term. That means it may not help reduce short term downtrends in your investments.
- Diversification is not a seesaw that investments ride! That means it isn’t necessary that if one investment goes up, another should come down.
The moral: Because all types of investments can go down at the same time, your only assured protection against sudden losses is to put some of your assets in Fixed Deposits.
Levels Of Diversification
There are three broad levels that diversification can be classified into.
- Diversification within investments – Let’s assume you owned only one stock. If that company does well, you get good returns. But, what if the company shuts down? Your investment goes for a toss. So, what do you do? You buy stocks from different companies to avoid such situations.
This is known as diversification across investments. Mutual funds do this for you by buying different stocks and managing them.
Additional Reading: How To Meet Your Goals With Mutual Funds
- Diversification across types of assets – The three main kinds of assets are equities, debt and cash. Asset allocation is diversification across different types of assets. By determining your asset allocation you reduce investment risks.
But, what happens when you own a mix of equities and bonds? Bonds or debt investments have a lower risk and give lower returns when compared to equity investments.
So, investment in bonds will make up for any losses you might incur by investing in equities. Equities have good growth potential, which is why you needn’t worry about getting lower returns from debt investments. All you need to do is get your asset allocation right.
Additional Reading: Intelligent Asset Allocation
- Diversification by sub-asset types – Stock is an asset class. So, what exactly would be termed a sub-asset? Well, large-cap stocks, mid-cap stocks or small-cap stocks would be sub-asset classes. Similarly, debt is an asset class. Bonds, Government securities and Fixed Deposits would be sub-asset classes. So, it is not only important to invest across asset classes, but also across sub-asset classes.
Additional Reading: Take Direct Exposure To Stocks!
Owning different assets is the right way to maximise your returns in the long run. So make sure you choose wisely before diversifying your investment portfolio.