How Important Is A Well-Diversified Portfolio?

By sarikamurty | January 14, 2016

How Important Is A Well Diversified Portfolido

You’ve probably heard it so many times, you now know it by heart: A well-diversified portfolio is the best way to minimize your risks!

But is it as simple as that? Of course not! For starters, one would do well to analyse how diversified your portfolio should be without going overboard and ending up acquiring an over-diversified portfolio which could be counter-productive in more ways than one.

First things first

Before you undertake any serious market research, ponder over what type of an investor you really are. Don’t try to be adventurous if you detest market fluctuations. Your portfolio should, therefore, be tailor-made to suit your own personal requirements and risk appetite.

Diversification =Don’t put all your eggs in one basket!

Diversification essentially means investing in a mix of asset classes to ensure you are not in serious trouble even if one of your investments goes awry. In other words, losses, if any, incurred on any of your investments, may be offset by profits earned by other assets.

You may want to diversify your investments if you consider the following observations:

  • Change is the only constant.

Different types of investments may not yield profits at the same time. For instance, supply and demand of essential commodities across the globe may influence and be influenced by current geopolitics and several micro and macro-economic indicators such as interest rates, inflation rates and exchange rates, among others. The combined risks of individual securities can help minimise risk.

  • The operative word is ‘risk tolerance’.

Risk is one of the seminal factors which drives consumers’ investments and rightly so. If you have a low risk appetite, it makes little sense to pursue high value stocks. Notwithstanding the possibility of high returns, your low tolerance levels for risk is not suitable for certain investment options.

  • Time, tide and market movements wait for no one.

Besides the obvious and important ‘risk’ factor, there is also the ‘time’ factor to consider. If you are one of those who wants to save money by pursuing specific goals, your investment strategy should be customized to suit your specific objectives. For instance, you may want to invest in bonds and short-term investments which are less volatile compared to stocks.

  • The correlation factor. 

The degree to which your investment options move together upward or downward helps you identify the right mix of investments. While building a diversified portfolio, you should include assets with returns moving in the opposite direction. Even if one asset is doing badly, another may be on the upswing, thereby nullifying or minimizing the negative impact on the portfolio.

  • A diversified portfolio should ideally be diversified not only between asset classes but also within asset categories to build an all-weather portfolio.

Below is a table showing different asset classes to choose from to build a balanced portfolio.

Cash Fixed income Equities
Savings Accounts Bonds Stocks
GICs Fixed income MFs Equity MFs
Money market funds Fixed income ETFs Equity ETFs

 

Here’s a lowdown on features of three major asset categories

  1. Stocks

Stocks traditionally offer the highest returns amongst all asset categories. However, stocks are highly volatile making them a risky investment.

  1. Bonds

Less volatile than stocks, bonds offer more modest returns. Certain bonds offer high returns akin to stocks but are more volatile.

  1. Cash

Cash equivalents such as savings deposits and money market funds are among the safest investments. However, they offer very low returns compared to other asset categories.

How much is too much?

While a diversified portfolio provides reasonable cover during volatile market conditions, most investments, by and large, take a beating in case of government default (rare) or a big market crash (possible).

Mutual fund holders are more likely to fall into the trap of over-diversification. Some large mutual funds hold hundreds of stocks, thereby, making it difficult for the fund to outperform indexes, which defeats the very purpose of the investment. Such overly diversified portfolios can result in high transaction costs and taxes. Also, investors may be unwittingly compounding risk instead of achieving the desired amount of diversification.

There is a view that over diversification is a result of consumers becoming mere “collectors of investments” instead of savvy investors. According to experts, you should be a “picker” as opposed to a being a “collector”. Failure to re-evaluate your asset-mix can result in over diversification, which in turn, can adversely affect your profits. Warren Buffett, perhaps best sums up the philosophy behind over diversification when he said: “wide diversification is only required when investors do not understand what they are doing.”

Balance is the key

Nevertheless, the importance of a well-diversified portfolio cannot be overemphasised. According to experts, investors seeking growth of capital and income over the long term should ideally invest in equity or equity related securities with limited exposure to debt securities and the money market, to strike the right balance in terms of diversification. However, as the popular saying goes, to each his own. You should look for the right mix of investment products to ensure that your personal financial goals and requirements are met. Good luck!

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2 thoughts on “How Important Is A Well-Diversified Portfolio?

    1. Team BankBazaar

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      Reply

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