What is Portfolio Diversification?
Portfolio diversification is a strategy of risk management used in investing, which allows you to reduce risks by allocating your funds to multiple asset types. This ensures that your assets are not exposed to high risks, but generate high enough returns at the same time.
Components of a Diversified Portfolio
The primary components of a well-diversified portfolio include: Bonds, Stocks & Mutual Funds
Stocks are the shares in publicly traded companies, and at the cost of volatility, you can receive exponential asset growth.
Bonds are corporate, and government debt instruments, where the volatility is less, but so are the returns.
Mutual funds dilute the risk associated with equities and also can offer stable returns.
Short Term Investments
Some examples of a low-risk assets are treasury bills, certificates of deposit, and commercial papers. They offer stability and make monetary access easier. However, the only drawback is the comparatively low returns against high-security levels.
You can add commodities like wheat, corn, metals or even oil to your portfolio. However, this is a risky asset class that is highly sensitive to the country’s economy, international markets, and trade scenarios.
Foreign investment instruments allow you to generate high returns on your overall portfolio since they have a lower correlation with domestic securities. You must analyse your risk appetite before investing in foreign stocks and securities.
Real Estate Funds
This includes direct/indirect investments in properties, buildings, and plots. Real estate can offer your portfolio some security against inflation. Unlike other assets, such as intangible shares, real estate exists in a tangible form.
Sector funds include sectoral focus and are beneficial if your investment goal is to take advantage of various economic cycle phases. These sectors can be communication services, energy, health care, technology, consumer staples, etc.
Advantages of Portfolio Diversification
It shock-proofs your portfolio.
It generates return opportunities across various sectors.
It allows you to mitigate risk.
Disadvantages of Portfolio Diversification
Over diversifying your portfolio can lead to below-average returns.
Researching and keeping a tab on their performance is a time-consuming affair.
With multiple stocks, you would also incur more transaction fees. This can increase your overall cost of investing.
Tax structures are not the same in all asset classes, which causes complications if you have ventured into multiple segments.
Things to Consider Before Diversifying Your Portfolio
Now that you know all the advantages and disadvantages of portfolio diversification let us go through a few things to consider before delving into portfolio diversification.
Reduce Your Risks
Spread your portfolio across asset classes. However, do thorough research and due diligence on each instrument and scheme before doing so.
If you feel managing your portfolio is challenging, approach a certified professional who can guide you through it.
Understand Your Goals
Understanding your investment purpose will ensure that your money is in the right place and you are not overly exposed to risks.
For example, if you are investing money in equity funds but your short-term goals, you may have a problem because equity funds tend to perform best in the long term and give you higher returns.
The Bottom Line
Investments are rewarding when you indulge in choices once you are well-informed about the market and the asset. Even though portfolio diversification is a smart choice for protecting your assets, over-diversification may result in below-average returns.
You need to remember the thin line between over-diversification and optimum diversification to not end up with complicated instruments and marginal returns.