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Posted On Friday, Apr 04, 2014
If you go to any financial advisor and ask them what is best way to secure your investments, there is a very strong possibility that he will ask you to diversify your investments.
“Diversification” is one term that is considered as a thumb rule for investments.
So, what is Diversification?
It is nothing but what we have been and will always insist you to follow – “Don’t put all your eggs in one basket”. However simple and obvious it might seem, many people even if they know do not actually follow this basic mantra of investing.
Mutual Fund allows you to diversify your portfolio in 2 broad ways:
1. You can either invest in a fund that in-turn invests your money in various other securities eg. A diversified equity fund or a multi assets fund
2. You can invest in different funds that match up to your risk appetite eg. Invest in equity fund, debt fund and gold savings fund.
Whichever way you choose, remember, it’s not good enough to simply own many different stocks.
As a prudent investor you need to wisely invest your money across various sectors - creating your own diversification.
How can someone diversify his portfolio?
Choose less correlated assets:
To build a diversified portfolio, an investor could look for assets whose returns haven’t historically moved in the same direction. When you put assets that have low correlations together in a portfolio, you may be able to get more return while taking on the same level of risk. The less correlated the assets are in your portfolio, the more efficient the trade-off between risk and return.
Invest in each type of investments:
Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment. One needs to strategies asset allocation in a way to get a blend stock, bond, short-term investments, etc. to achieve different levels of risk and return potential.
Rebalancing is important:
Diversification is not a one time job. Once you have invested your money across asset classes, keep it on track with periodic checkups and rebalancing. If you don’t rebalance and if you have lets say invested in equity fund, a good run in your equity stocks could leave your portfolio with a risk level that is inconsistent with your goal and strategy. Ideally one needs to monitor your investment mix and rebalance it at least annually, or whenever your financial circumstances change.
How diversification helps?
Every investor needs to keep in mind that equity markets are volatile and will always remain volatile. Secondly, within a portfolio there is no substitute to diversification. So, moving completely out of one asset class because it is volatile or investing into an asset class only because it is volatile and gives you potentially high return over the long term may not be a wise thing to do.
Let`s say for example there are three portfolios, A, B and C. Portfolio A is the most conservative with an asset mix of 85 per cent risk-free assets such as government bonds and 15 per cent risky assets such as stocks, commodities and corporate bonds, both onshore and offshore. Portfolio B is slightly more risky with a 70:30 mix between risk-free and risky asset classes, whereas, C is tilted towards growth with a 50:50 mix.
Because of the different mixes of assets among the three portfolios, they have different levels of risk and expected return. If the year turns out to be really good as markets performing well touching new highs, portfolio C would score on top followed by Portfolio B and Portfolio A. Whereas, if the scene is reversed and the year turns-out to be really bad with markets plunging dramatically, it would be the Portfolio A that will be the most insulated and will perform comparatively good as compared to Portfolio B and C.
Prudent asset allocation plays a very important role in diversification.
Remember there is no investment that is risk free and guarantees returns. When you invest your money in any instrument there is always some amount of risk associated with it and cannot claim any returns. However, achieving your long-term goals requires balancing risk and reward. Choosing the right mix of investments and then periodically rebalancing and monitoring your choices can make a big difference in your outcome. You can also consult your financial advisor before making any investment decisions.
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