Why Is It Crucial To Diversify Your Investment Portfolio?

By | February 16, 2019

When it comes to investments, it’s necessary that you have a well-diversified portfolio. Don’t believe us? Read on to know more.

Speaking of investments, there is a plethora of information available at your disposal. However, what often goes unnoticed is the need to have investments branched out across different avenues. If you think it’s too complex, we’ll break it down for you. Don’t you worry, keep calm and read on.

First things first, let’s talk about portfolios.

  • What is a portfolio?

When you invest your money in various instruments such as Mutual Funds, shares and stocks, and Fixed Deposit with an intention to generate profit or extra income or return on investment, then the pool of money invested is known as your “portfolio of investment”.

For instance, let’s assume that you’ve invested a sum of Rs. 1 lakh in any investment option. This sum is called your investment portfolio.

For a new investor with limited funds, the Mutual Funds or shares may be more suitable portfolio options. Whereas, for an experienced individual with surplus funds, it should include shares, bonds, real estate and/or precious metals etc.

Now that you know what an investment portfolio comprises, it’s time to know how to diversify it.

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  • How to diversify your portfolio:

As we know, each investment or asset type has a certain amount of risk connected to it. Generally, the Equities are considered to be the most profitable investments over the long run. At the same time, they are famous for the high risk associated with them. The risk not only varies from one investment instrument to another, but it also varies under each investment category.

For instance, investing in shares in the infrastructure sector may be riskier than that in banking. It is believed that higher the risk, higher is the return. But you, as an investor, might not be ready for high risk and might not want to compromise on your return either. In such cases, the diversification of your investment portfolio can help you reduce the level of risk and fetch considerable returns too.

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Diversification works best when you have a mix of investments. Wondering why? It’s really simple. Imagine putting all your eggs in one basket. It’s risky, right? If you drop the basket, you lose all your eggs at the same time.

Here’s how diversification works. Poor returns from one of your returns can be compensated by remarkable returns from another.

Suppose you want to invest Rs.1 lakh in buying stocks. Then, you’ll have the following options:

Option 1: Invest in stock A, which has an expected return of 15% with a standard deviation (risk) of 20%. This leaves you have 80% chance of making 15,000 if you invest your money in Stock A.

Option 2: Invest in stock B, which also has an expected return of 15% with a standard deviation (risk) of 20%.

Both Option A and B are from different sectors and are not correlated, which means, if you choose to invest your complete amount in one of these sectors, then your funds are equally exposed to the similar risk.

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On the other hand, if you divide your investment value into equal portions of Rs. 50,000 each, then you are spreading your risk associated in each class. For example, if after a few days, something goes wrong with stock A sector, then you are still on a little safer position as the stock B is not correlated with any market tabulations in stock A. And if everything goes well, then you are anyway getting equal returns of 15% from both sectors. Sounds great, right?

This way, your overall returns remain the same, while only the risk gets distributed. So, as you can see, diversification of your funds allow you to divide the risk and play your game safely without compromising on your returns.

Now that you’re aware of the benefits of well-diversified investments, you may be wondering about how to choose your investments options keeping the rick factor in mind. Let’s get cracking!

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  • What is the level of risk associated with various investments:

So, whenever you invest your hard-earned funds into investment avenues, you are always exposing your money to a certain amount of probability. The risk, however may range from low to high depending upon the type of investment you’ve chosen. Highly profitable investments like stocks may be relatively riskier than the safe but low-yield Fixed Deposits and bonds.

Investments usually have following combinations:

  • Low risk-> Low but certain yield, and fixed and steady returns
  • High Risk-> High but uncertain return; variable but with exponential growth
  • Medium risk-> Medium/Low but with fixed returns and much more.

The primary objective of an investment should be to make profit after preserving the principal or the actual sum invested. So as to attain this goal and earning a reward on your portfolio, you should follow these golden rules we’ve listed below. It is always advisable to verify these check-points before you make any decisions.

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  • Know your risk-appetite

Before you jump into any investment, you should do a self-analysis about your risk appetite and risk tolerance. Your risk appetite determines your readiness for taking a risk, whereas your risk-tolerance determines your ability and sustainability to do so.

You should ask yourself a few questions like- What if market falls and I lose my principal invested? Will I be able to survive the risk of losing this amount of money? Will I be able to take the risk with a lesser amount of funds? What other alternatives do I have for investing my funds?

Your age, experience, and knowledge contribute a lot to your risk taking ability. While on one hand the risk taking ability reduces with the age, on the other, it increases with experience and knowledge.

  • Take diversification seriously

Diversification is key to reducing the risk associated with any investment. Just as the “location” is the most important criterion while buying a property, similar is the case with investing your money in market-related funds.

As returns are uncertain due to market volatility, the risk can however be reduced once you diversify your portfolio of investment. Fund advisers always suggest their clients to diversify their portfolio ranging from low, medium-risk to high-risk investment vehicles.

Your investment should be an assortment of vehicles, to spread the risk of possible loss due to sub-par performance of one or a few of them.

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  • Increase your financial literacy

Improving your financial knowledge helps you understand the host of options available in the market. Once you gauge the risk and returns associated with each, you’ll be able to derive a certain idea of how well-suited it is to your goals, following which, you can cherry-pick the best one that works for you.

Being well-versed with financial products not only instills the confidence to invest but it also saves your time, money and effort involved in seeking financial advice.

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  • Risk vs. Return

Can’t stress on this enough! Always, always do a Risk vs. Return Analysis before you invest! Identify the risk associated with a particular investment instrument and its potential return. This helps you in determining the percentage of debt and equity exposure you are comfortable with.

Research is everything. Studying about a particular investment and its sector further helps in making informed decisions.

  • Liquidity needs

Everyone needs Liquid Funds but the amount and timing for liquidity varies and depends on an individual’s lifestyle, family expenses, contingency planning and a number of other factors.

Before you invest in any long-term funds, you should always take stock of your future requirements. We suggest you factor in expected circumstances that might a bearing on your monetary needs. We’re talking about life events such as a wedding in the family, the rising expenses of college education for your kids, and also unfortunate events such as bankruptcy or an untimely demise.

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And here comes one of the most important things to take into consideration before you put on the mantle of a smart investor. Ask yourself this, ‘What are my long-term and short-term goals?’

Once you have a clear picture, you’ll be a step ahead in terms of choosing the investment vehicle that works best for you. Now that you know the pointers you should keep in mind while investing, do you want to check out the options we have in store for you? There are plenty. Happy investing!

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