Importance of Diversification
Usually, we invest in instruments that offer high returns. But as there is a well-known phrase that “Do not put all your eggs in one basket”, one should be cautious in making an investment decision. When you invest by just looking at high returns, you expose yourself to high risk as well as high return comes attached with high risk. This is where diversification of a portfolio helps.
Diversification is the key to maintain risk levels at the lowest and make a most effective investment plan. Considering the current movement of the market, a diversified portfolio will help distribute financial risks across different investment avenues and different sectors to maintain a balance.
Diversification is spreading the risk across different types of investments. This is done because the goal is to increase your probability of investment success. In other words, we can say since no one can know for certain which investment is going to win the race, so let’s bet on every investment avenue.
Now let us look at the current situation where the equity markets have fallen sharply since the month of March owing majorly to global pandemic. If someone would have invested everything into equity markets then he may be suffering huge losses in his portfolio. Therefore, it is crucial that you diversify your portfolio beforehand and be prepared for such situations in advance.
It is important to diversify your investments because markets can be volatile and unpredictable. By diversifying your portfolio, you reduce the consequences of a particular asset class not performing.
Still unclear about what is Diversification?
Let us understand from the very basic. There are different options available for you to invest. Based on how these investments react to economic conditions, these investments are grouped into a few categories called asset classes. These are
- Equity
- Debt
- Commodities like Gold
- Real Estate
- Cash or liquid assets
One should have exposure to each of these asset classes. The proportion can be based on the age and risk profile of the investor. For example, if a person’s age is 25, then he should have more exposure to equity upto around 70%, 25% in debt and 5% in Gold. On the other hand, if a person is 40 years old then the allocation should be Equity- 55%, Debt – 35%, Gold – 10%. For a person who is near to retirement at age 50 or more, allocation can be done as – Equity – 35%, Debt – 55%, Gold -10%. This is just to give you an idea, the allocation can be changed based on the risk profile of the investor and nature of his goals.
Even in the same asset class, one should diversify. For instance, if you are investing in equity, you should be diversifying across different sectors.
In other words, we can say that diversification is holding investments which will react differently in the same market conditions. For instance, when the economy is improving, stocks tend to outperform bonds. But when the opposite happens and we experience a slowdown in the economy then bonds often perform better than stocks. So by investing in both stocks and bonds, you reduce the risk of your portfolio taking a huge hit when markets are volatile.
Let us see some of the advantages of diversification:-
Reduces the impact of market volatility
Investing across different funds ensures that sector specific risks are low. For instance, if you have invested in the pharma sector as well as real estate sector, so even if the real estate sector is not performing your overall portfolio will not be impacted much as it is just one part of your portfolio. Thus, it reduces risks and generates higher returns in the long run.
Take advantage of different investments
By opting for mutual funds, investors may gain the benefit of investing in a mix of debt and equity. In the same way, by investing in fixed deposits, investors benefit from a fixed return and a low risk. Hence, diversification of the portfolio will balance the risk and return associated with different funds. Even if one fund does not perform well, the loss may be compensated by the profits made from other funds.
Read this article for other investment options – Checklist for your Investment portfolio in 2021
Provides peace of mind to investors
The most important advantage of diversification is peace of mind. As your total investment is divided amongst a number of asset classes, you will not feel stressed about the performance of the portfolio.
On the other hand, if someone would have invested everything in a Fixed Deposit in the same bank and that bank shuts down or a moratorium is imposed for a certain time, then you will not have any option to protect your wealth.
We can relate to the recent Yes bank crisis here and the plight of deposit holders for a few weeks when the bank was under moratorium. If such deposit holders also had money invested in other investments, then there would have been much less panic for immediate requirements.
Conclusion
Diversification can help you manage risk and reduce the volatility of an investment price movement. However, it is important to note that no matter how diversified your portfolio is, risk can never be eliminated completely. But yes, you can reduce it to a great extent. The key is to find a balance between risk and return. So, Diversification is important in investing because the future is uncertain and it will help you achieve all your financial goals.
You may get in touch with our finance experts at Fintoo who can help you to diversify your portfolio and maximize returns.