Series – V: Why diversification is important for Portfolio.
Diversification is a risk management strategy that involves investing across or within asset classes to reduce the overall risk of an investment portfolio.
One of the most important foundational principles of investing is to ensure that you have a diversified portfolio.
Conventional saying – “Don’t put all eggs in a basket.”
One should ensure that the capital is spread amongst different stocks and sectors so that it is not dependent upon a single stock for all returns and helps offset the ups and downs of the market.
As markets are volatile & unpredictable, diversification does not guarantee to entirely mitigate losing probability but it can help the investor to minimize this probability and one can avoid creating unwanted risk to his / her capital.
Some of the benefits of diversification
Key advantages of diversification include:
- Lowering risk
If a portfolio is well-diversified; one investment performs poorly over a certain period, other investments may perform better over the same period and if something goes wrong with one stock, it only accounts for a small proportion of your investments and therefore won’t be too detrimental to your overall wealth, thus reducing the potential losses.
- Lowering volatility & smoothing out the return
If one is holding a variety of non-correlated stocks in the portfolio, this kind of diversification will safeguard against adverse market cycles and reduces volatility. In other words, by owning stocks in different industries and companies, industry and company-specific risk is minimized and also results in smoothing out the returns of the portfolio as a whole.
What makes asset allocation important in the process of diversification?
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. Give a glance at your stock portfolio now. If you have invested heavily in one / two-sector, you could be in trouble. If one of the sectors you are invested heavily crashes then the loss can be exponential comparing your entire invested money. Remember technology burst in the 90s. Through proper asset allocation, you can gain a measure of protection against such crises.
What should be my assets allocation strategy?
It’s depending on your age, source and type of income, personal and professional liabilities, future goals. Time horizon and goals of investment play a significant role here, not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital while young individual seeks for extraordinary returns. For example, A 30 year old job professional can take more risk than a 60 year old investor. (Keeping rest all same in both cases).
How to diversify your portfolio
There are three financial statements available for a company
Diversification is not a number game, owing a large number of stocks will not help you to win the game.
There are various ways of diversifying your portfolio, think yourself as a selector of the cricket team; the team only with great batsmen won’t work. You need a well-rounded team along with bowlers, fielders to increase the probability of winning the crown. The same rule applies to your portfolio.
Wrapping up :
To diversify your equity/stock portfolio, you need to spread your capital across different sectors/industry to reduce your overall investment risk. These should include a mix of both growth and defensive stocks with proper asset allocation. It is important to review your investment portfolio regularly to make sure the asset allocation is still meeting your investment objective.
Sanskrit idiom says – अति सर्वत्र वर्जयते (Means – Excess of everything is bad).
While diversifying your stock portfolio, keep in mind that over-diversification is harmful, as it can eat-up your returns. It is always advisable to speak with your financial adviser.
Goldmine Stocks provides health check-up report of your equity portfolio. One can avail of this service.