Everything that you do, there are a variety of options to choose from. Whether selecting a flavor of ice-cream, or the clothes to wear. Do you select the same flavor of ice cream or the same set of clothes every time?
When it comes to investments, there are also a range of options available. It is important to work out the right option. The same option will not suit your needs every time. You really need is a large set of options to choose from which can take care of your requirements.
It is easier to understand with an example. Suppose you invested in stocks or shares of an airline company. Your friend Arnav invested in airline stocks and in FMCG stocks. Your cousin Tanya, on the other hand, invested in airline stocks, FMCG stocks and gold.
One morning you hear that the airline staff is going on strike. You start fretting because the value of your airline stocks goes down. All three of you lose some money. However, Arnav and Tanya were not as worried as they had other investments in their portfolio and hence are exposed to less risk than you.
A few days later the government announces a policy that negatively affects exports and imports of the FMCG company. Arnav and Tanya both lost money as the value of their FMCG stock crashed. At the same time gold prices rose smartly which helped Tanya balance her losses and maybe earn some profit.
What did Tanya do right? She was a smart investor as she diversified her portfolio better than Arnav or you. She ensured that she bought a good mix of assets with different features to better withstand the volatility of the market. Even if one part of her investment portfolio went down, the others could balance it out.
Therefore, diversification is a risk management practice of ensuring that your portfolio has a balanced mix of assets, in order to withstand market volatility. The practice is done across asset classes (such as equities, fixed income, cash, gold and real estate) and within each asset class (for example, in case of equity, across geographical regions, industry sectors, market capitalization, etc.). Experts suggest that a well diversified portfolio will better manage the risk you take and usually ends up delivering better results for your portfolio in the long term.
Earning optimal returns
Diversification helps the investor achieve optimal returns since investment products perform differently over time. For example, it is observed that when equity stocks rise, bonds tend to fall. As an individual investor, it is really difficult to correctly time your entry and exit from investments to maximize your returns. It becomes clear that holding a diversified portfolio is in your best interest.
There are three reasons to diversify:
- Not all types of investments perform well at the same time.
- Different factors influence different investments: Particular investments are affected differently by world events and changes in economic factors such as interest rates, exchange rates and inflation.
- Helps you manage investment risk: Diversification enables you to build a portfolio whose overall risk is lower than the risk of holding only one type of investment.
Are there different types of diversification?
Yes, you can diversify your portfolio across and within asset classes.
- Across asset classes – equity, debt, gold, property
- Within an asset class – across geographies, sectors, market capitalization, etc. in case of equity; across bonds of different tenures and from different issuers in case of debt.
If diversified, a range of investments will cushion your portfolio against different external factors.
A great way to diversify is by investing in Mutual Funds. They enable you to diversify your portfolio across products, sectors, industries and geographies, without you having to worry about selection of the right assets. This is because an expert is constantly reviewing your portfolio and managing the risk. In an equity mutual fund, you will see stocks of many companies in the portfolio. However, the portfolio will also have a percentage of holdings in bonds or cash equivalents, and so on. This is diversification – providing a shield against volatility and also providing liquidity to the fund.
However, beware of over-diversifying. If you hold a portfolio with too many similar assets, in small amounts, then you risk under-performance in your portfolio. For example, investing small amounts in stocks of a large number of companies in a particular sector or investing small amounts in too many mutual funds with the same investment objective and philosophy (say, investing in too many equity diversified funds). Diversification is good, but it has to be sufficiently balanced with concentration. This is because diversification helps mitigate risk while concentration helps earn returns.
An investment advisor can help you structure a well diversified portfolio.
- Diversification is important in any investment strategy, in order to protect against losses and to optimize returns.
- Diversification can be done across asset classes and within a particular asset class.
- There are some external risks to your investments that you can never control or predict; diversification helps you to mitigate those risks.
- Balance diversification (objective being managing risk) with concentration (objective being earning returns)