The stock market is highly dynamic and it is almost impossible to predict its movements. This makes investing a risky affair and one of its vital counterbalance strategies is portfolio diversification. Diversification, or distributing your investments among various asset classes, has been one of the most effective ways of mitigating risk. Diversification in the investment portfolio ensures that your assets are not exposed to high risks but generate high enough returns at the same time.
This article explores portfolio diversification, its components, merits, and demerits, along with a few things for you to keep in mind while preparing your strategy.
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 in multiple asset types. Not only does this help to mitigate the associated risks, but it also boosts the returns on your overall investment portfolio.
The main principle of diversification is to avoid putting all your eggs into a single basket. The entire idea is that you effectively manage your risk and average out the volatility. That being said, not all markets and asset classes function alike. This is why you can include some high-risk, high-return shares in your portfolio and, at the same time, incorporate safe investments. If one investment falls in value, another investment will grow if the portfolio is well-balanced.
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Let us now note all that is required to build a well-diversified portfolio.
Components of a diversified portfolio
The primary components of a well-diversified portfolio include the following investments:
Bonds, stocks & mutual funds
During portfolio diversification, most investors decide the percentage of funds they wish to allocate to each asset class. That being said, the leading asset classes include bonds and stocks. Stocks are the shares in publicly traded companies, and at the cost of volatility, you can receive exponential asset growth.
Mutual funds, on the other hand, are schemes that invest in the equity markets and other investment instruments through a pooled corpus. They dilute the risk associated with equities and also can offer stable returns.
Bonds are corporate as well as Government debt instruments, where the volatility is less, but so are the returns.
Short term investments
This is another low-risk investment asset class that includes cash and short-term cash equivalents. Some examples of this are treasury bills, certificates of deposit, and commercial papers. They offer stability and make monetary access easier. However, the only disadvantage is the comparatively low returns against high-security levels.
Smallcases are a great tool to use if you want to diversify your portfolio and include some short-term investment vehicles. Check out our blog of the best smallcase options to choose for short-term investments here!
Commodities
Commodities are another type of asset class that you can consider for diversification. For example, you can add commodities like wheat, corn, metals (silver, gold, copper, zinc, and more), or even oil to your portfolio. Keep in mind that this is a risky asset class that is highly sensitive to the country’s economy, international markets, and trade scenarios. It is advised to do thorough due diligence before investing in these commodities.
Foreign assets
Foreign diversification includes investing in foreign stocks and securities. Foreign investment instruments allow you to generate high returns on your overall portfolio since they have a lower correlation with domestic securities. For instance, the stocks of US companies will not function like non-US companies. Thus, both potential returns and threats will vary considerably. Nevertheless, just like in the case of any other investment, it is essential to analyse your risk appetite before investing in foreign stocks and securities.
Real estate funds
These include direct/indirect investments in properties, buildings, and plots. Real estate can offer your portfolio some security against inflation. Unlike other assets such as shares that are intangible, real estate exists in a tangible form.
Sector funds
Sector funds are a form of stock investment. They 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 diversification of portfolio
Portfolio diversification is a crucial aspect that must be kept in mind while investing. It provides cover against unwanted risks while allowing you to venture into high-risk and high-return securities. Apart from this, diversification offers the following benefits:
It shock-proofs your portfolio
In the case of a downward spiral in the market, a well-diversified portfolio makes sure that your losses are minimal. The risk is distributed across asset classes, and no single asset will have to take the downfall. Similarly, if you have one non-performing asset, others will make up for it. Your portfolio will, thus, have enhanced stability.
It generates return opportunities across various sectors
Due to separate economic cycles and business conditions, market performance varies for different sectors at a point in time. Diversification ensures that you get the opportunity to explore returns from multiple industries and reap the benefits of fluctuations.
It allows you to mitigate risk
A diversified portfolio ensures stability because all of your investments will not function poorly simultaneously. For example, if all your investments are in equity shares, and the market suffers a blow, then your debt or commodities do not need to suffer as well. With diversification, the risk factor is reduced.
Disadvantages of diversification of portfolio
All things suffer a slight downside. For portfolio diversification, the few disadvantages that you must be aware of are as follows:
- Keep in mind that balance is necessary. Over diversifying your portfolio can lead to below-average returns. However, risk is a prerequisite for beneficial returns.
- Portfolio management becomes a time-consuming affair. You must research various segments and keep a tab on their performance. To get some relief, you can consult with the experts at Teji Mandi, who offer advice and manage your portfolio in a way that aims to generate favorable returns.
- With so many stocks, your portfolio can quickly get complicated. You must have a proper system in place that allows you to keep a check on all of your investments.
- 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. You would have to ensure that you comply with all the rules mentioned separately in different sections of the Income Tax Act. Moreover, deductions that you can claim must be kept in mind to get all the available tax benefits.
Now that you are aware of all the pros and cons of diversification, you are well-equipped with the information you need to employ this strategy. To top this off, let us go through a few things that you must keep in mind before delving into portfolio diversification.
Things to keep in mind before diversifying your portfolio
The two main things to build your strategy around are your risk profile and your ultimate financial goals. For this, you must:
Reduce your risks
The goal of diversifying your portfolio is risk reduction and increasing your returns. 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 difficult, it is advised to approach a certified professional who can guide you through it. Teji Mandi offers excellent solutions for portfolio diversification based on your risk profile.
Understand your goals
Is your goal to achieve long-term or short-term gains? 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 goals are short-term, then you may have a problem. Why? Because equity funds tend to perform best in the long term and give you higher returns. You can only make an informed decision if you know your end goal.
The takeaway
Investments are rewarding only when you indulge in choices once you are well-informed about the market and the asset. Portfolio diversification is a smart choice for protecting your assets and acts as a growth catalyst. In addition, your knowledge base of investment options is broadened when you opt for diversification. However, you need to remember the thin line between over-diversification and optimum diversification to not end up with complicated instruments and marginal returns.
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