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Why an investor needs diversification?
One of the most fundamental rules of market is not losing money in the market, and that is exactly where portfolio diversification comes in handy. It follows the age old saying which many of us can relate to: "Never put all your eggs in the same basket". In terms of finance, we put it: "Never invest all your money in a single asset class". If you are new to investments, start here.
The concept out here is that different asset classes perform differently all the time, i.e. gold prices rise when stock market volatility is high, debt instruments like bonds surge when returns from stocks/gold is low etc. Diversification provides optimised returns and also stabilises portfolio in the times of volatility. We should although understand that, diversification is not a return maximisation strategy, it is return optimisation, i.e. you don't earn highest possible return but it minimises risk of loss* and still provides good returns.
What are the types of diversification?
So now when we know the benefits of diversification, let's dive into the types of diversification strategies we can use:
1. Inter-class diversification: This strategy employs diversification of investments between different asset classes like: stocks, bond, gold and real-estate.
2. Intra-class diversification: Here an investor diversifies within an asset class. Example: Investing in stocks from different sectors (infrastructure vs pharmaceutical vs banking) or in stocks of different company sizes (i.e. small, mid and large cap). Please note that diversification is not about investing in multiple stocks, it's about investing in diverse stocks (where performance of one stock is not related to other). You can
How to achieve diversification?
An investor can go about 2 different ways for achieving diversification in their investments:
1. Manually: Using one's demat account, build a diversified bucket of assets manually.The pros and cons of this approach are:
Pros: You are the decision maker, w.r.t individual picks, this is recommended for investors with more than average investment experience. Involves higher risk & returns, also gives more control to an individual over their portfolio.
Cons: Requires considerable investment knowledge and is time consuming. Involves higher risk and an active management of portfolio.
2. Automatic: Leverage thematic mutual funds (small/mid-cap/large/hybrid/debt) to easily diversify your investments. Learn about mutual funds here.
Pros: Easy to achieve, doesn't require significant financial knowledge. Can be managed passively.
Cons: Loss of control over portfolio, which is manageable given the efforts required in manual diversification.
The asset class diversification combinations available are:
Equity + Debt: This is the most basic and yet effective (due to simplicity) option available for most investors who are starting investments for the 1st time. This option also comes with the traditional with a simple equation to define your investment mix. The equation is: 100 - your age = % investment in Equity, i.e. for an investor of age 30 years, equity investments should be 100-30 = 70% of his/her portfolio. This wisdom behind this formula is that when we are young we have higher risk appetite because we can stay longer in market (and can sustain a bad year by buying on dips) versus when we get old and have lower risk appetite. Hence, at young age we should try maximising our corpus, versus in older age when we need to preserve our corpus. Check out our stock recommendations here.
Equity + Debt + Gold: The portfolio follows the a similar equation as above, just that Gold becomes a hedge (alternative investment vehicle) to guard against simultaneous downturn in equity and debt markets. Generally Gold should hold 2.5% to 5% in your entire portfolio under this diversification strategy.
Equity + Debt + Gold + Real estate: This is the most popular investment mix of most Indian households. The general mix of asset out here is, Real estate: 50%, Equity: 20%, Gold: 10% and Debt: 15%. This portfolio is although very well diversified but is over-weight on real estate (which is not a liquid asset), and hence has higher exposure of risk. This portfolio is well-suited for people who are not well-versed with equity investments and/or are really good with picking the right real estate deals (without taking a huge loan). This kind of portfolio minimises volatility risk but has a downside of offering lower returns and/or returns based on the performance of real estate sector mostly. The good news is that over-exposure of this portfolio to real estate can now be optimised, check out how.
Thus diversification is something which can be achieved by any investor and is a strategy which optimises returns. The type of diversification and mix of assets is something which an investor should choose based on his/her own expertise and risk profile.
Over-diversification [a performance killer]
Just like any good thing when done in excess results in negative impact, over-diversification of one's portfolio also results in sub-optimal performance. Over-diversification results from investing in way too many stocks from each sector, thus your portfolio starts mirroring an average basket of stocks from market and delivers average performance. Also, managing such large portfolio is a tough task as well and may often result in losses.
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