In investment, we often hear the phrase, “Do not put all your eggs in one basket”. Putting all your eggs in one basket is like investing every dollar in one asset. You will lose all your money if that asset value falls to zero. Investment portfolio diversification is an important concept that means investing in many assets.
There are two ways to diversify. They are:
- We can invest in multiple asset classes.
- Within each asset class, we can invest in many assets.
Diversification helps to reduce the risks. For instance, on rainy days, sales of umbrellas go up. So, rain and umbrella sales are positively correlated. Similarly in finance, when assets A and B are positively correlated, their returns move together in the same direction.
And, when they are negatively correlated, their returns move in opposite directions. You can compensate a loss in one asset by a profit in the second asset to a certain extent. Hence, we get more diversification benefits when the assets are negatively correlated. The best we can do is diversify our investments across multiple assets that are least positively correlated.
One common misconception of investing is “the more stocks, the merrier”. But we often get no additional diversification benefits by having beyond 30 stocks in our equity portfolio. Thus, diversification is not about including as many assets as possible. It is about reducing the correlation between assets in our portfolio.
IMPORTANCE OF DIVERSIFIED INVESTMENT PORTFOLIO
To reduce the overall risk, we should always try to diversify our investments in the following instruments:
- Real estate
- Crowd funding
To decide on the diversification, first, decide the risk appetite and the objective at hand. Then, analyze the historical trends for the returns given by the asset classes. And allocate the funds according to the risk that you can face.
Some importance of diversified investment portfolio are:
- Balances exposure:
Portfolio diversification helps investors protect themselves against wide swings in main sectors. Typically, investors diversify by trading both equities and bonds. They allow market participants to hedge against market risk.
- Reduces risk:
Diversification is about spreading your risks. If you have a large investment portfolio or a large investment bank, you may want to spread out your risk. In case of a huge catastrophic event or a market sell-off, you want to be diversified. In that way, one thing does not take a huge dive. For minimizing the risk, maximum investment should go to the asset that has the least fluctuations.
- Does not reduce the return
Diversification allows you to reduce your risk by spreading your investment across different assets. The great thing about a diversified investment portfolio is that it is a free lunch. It means it reduces your risk without reducing your return.
- The process is simple:
Modern financial markets make it easy to diversify. One of the easiest investments is in index funds. Index funds are low-fee funds. They simply mimic a large market basket. Do not limit your diversification to stocks from your home country. That is called home market bias. It is quite easy to diversify internationally by buying an international index fund or multinational companies.
- Capital preservation:
When risk appetite is less, the diversification route is best as it allows you to preserve your capital.
- Better returns:
The overall returns are better for the diversified portfolio as the growth and degrowth in various asset classes get averaged out. For maximizing the returns, the maximum investment should go that had maximum returns.
We should analyze the performance of the portfolio once we have invested. If expectations are not met, we should reallocate the funds.