Every investor invests in different financial instruments across asset classes with different levels of return. Every instrument has a certain level of risk associated with it, and investors also have a certain risk tolerance level. Thus, diversifying your assets is one way to balance the risk and reward in your investment. Portfolio diversification is the practice of spreading your investments to build a proper asset allocation to reduce volatility and achieve your financial objectives.
What is Portfolio Diversification?
Portfolio Diversification is a risk management strategy that mitigates risk by allocating investments across different financial instruments, industries, and other categories. This strategy aims to maximise returns by investing in different instruments that would yield high long-term returns. However, this strategy does not provide guaranteed returns. It only aims to achieve the financial objectives while mitigating risk.
In simple words, diversification aims to balance the unsystematic risk occurrences in a portfolio. If some asset performs positively, it neutralises the other asset’s negative performance. Thus, it works best when the assets are not correlated, i.e. they react differently to market conditions.
A portfolio can be diversified across asset classes, sectors as well as geographically by investing in domestic and foreign markets. The different asset classes are –
- Stocks – publicly traded company equity or shares
- Bonds – government or corporate fixed income securities
- Real Estate – buildings, land, livestock, agriculture, water, mineral deposits.
- Exchange Traded Funds – a basket of securities that follow an index, commodity, or sector. It is listed on the stock exchange.
- Commodities – materials that are required for manufacturing other products /services.
- Cash or Cash Equivalents – savings account, certificate of deposit, treasury bills, money market instruments, and other short-term, low-risk investments.
Learn About Money Market Instruments
How to Diversify Your Portfolio?
Portfolio diversification is one of the core components of investing and risk management. Here are some tips on how to diversify your portfolio –
The first step for diversification is understanding your risk tolerance levels. Risk tolerance level means how much money you can afford to lose. Therefore, as an investor, you should be able to take the short-term and long-term market fluctuations. Also, you shall have enough liquid assets parked to help you sail through volatile situations. However, this does not mean that all investments have the chance of running into losses. It completely depends on the investment instruments. Hence, you can choose a portfolio of investment instruments based on your risk tolerance level.
Aligning Risk Level with Investment and Goals
The next step is to analyse the risk level associated with different investment schemes. Every investor builds a unique diversified portfolio. For instance, a high-risk tolerance investor may invest more portion of their portfolio towards equities while a low-risk tolerance investor may prefer fixed income instruments. Therefore, based on your risk tolerance level, you can pick asset classes and securities that help you meet your financial objectives. Also, it is beneficial because if you incur a loss in one asset class, other asset classes and securities can compensate for the same.
Spread Your Investment
It is essential to diversify your investment within the asset class too. For instance, if you invest in equities, you should not allocate all your money to a single stock. Therefore, you must diversify your investment in different sectors and industries within an asset class. Also, adding instruments with different risk levels and those following different market trends can benefit the portfolio.
Know When to Exit
A portfolio diversification strategy also entails knowing when to exit from your investments. For instance, if you are investing in an asset class that has not performed as per the expectations over the period or there are any changes in the fundamental attributes of the asset, then you must exit. However, if it is a market-linked instrument, then do not exit based on short-term volatility. Therefore, you must keep a constant check on your portfolio investments.
This is another important factor to watch out for. If you are taking the services of any professional, then always check the fees you will be paying and compare them with the market. If the fees are high, it can eat away your overall gains.
Benefits of Portfolio Diversification
Portfolio diversification is crucial and is one of the important principles of investing. Diversification helps to build a strong portfolio. Therefore, the following are some benefits of portfolio diversification –
- Diversifying the investments across various asset classes helps to mitigate the portfolio risk and helps it grow.
- A well-diversified portfolio helps to absorb shocks during a market downturn. Therefore, the non-performance of one asset class is covered by another asset class.
- Another significant benefit of diversification is risk-adjusted returns. A diversified portfolio will have lesser risk, better returns and less volatility.
- By diversification, you get to learn about a plethora of investment options. Thus, it makes you well-versed in market conditions.
- Investing in different asset classes in different sectors can help to leverage the growth opportunity present in them.
- It helps you explore and follow multiple investing strategies, from value to growth investing.
- Through diversification, you can also get an opportunity to invest in other foreign markets apart from the domestic market.
- It gives your portfolio the much needed stability and peace of mind, as it can combat the market downturn. Also, different asset classes help to achieve the desired goals by aligning them.
Therefore, portfolio diversification can only help to mitigate risk and reduce the volatility of the asset’s price movements. It helps to create a balance between risk and return. However, you must understand that no matter how diversified your portfolio is, complete elimination of risk is not possible.