We all know this proverb ‘never put all your eggs in one basket’ and often use it when it comes to money matters. But, when people think of investing, they often assume it to be about allocating available funds in a few areas and possibly keeping a track of performance over time. Investment is a multi-dimensional process and involves various steps. However, for an individual to be successful at investment, one of the core elements to look after is portfolio diversification.
So, what is portfolio diversification? It may sound like fancy terminology, but it is a very simple approach to successful investing. Here is all you need to know about portfolio diversification and why it is crucial.
Meaning of portfolio diversification
Portfolio diversification involves allocating funds available for investment in different asset classes. To diversify an investment portfolio, it is important to begin by identifying personal financial goals. Also important are factors like investment horizon, personal risk appetite, age and income. Factors like age can help you in identifying the right assets to invest in and the number of funds that should be allocated to each.
The process of portfolio diversification does not stop at successfully allocating assets to create a portfolio. It is equally important to constantly monitor the performance of the investments and, depending on the performance, rebalance the portfolio from time to time. These additional steps will help in ensuring that financial goals are met on time and as per plan.
Why is portfolio diversification important?
Mentioned below are some of the factors that highlight the importance of portfolio diversification:
- Protection against risks
Investing money may come with varying degrees of risk. However, it is important to invest in order to generate inflation-beating returns for a secure financial future. To protect against the resultant investment risks, we must adopt portfolio diversification. This way, we can spread the available funds for investment across different assets like stocks, debt, bank deposits, gold, real estate, etc and protect against the volatility in any sector. For example, if stock markets are not performing well, we can rely on gold and real estate investments to balance off the overall risk of loss.
- Exposure to a variety of sectors
With portfolio diversification, we essentially invest across different sectors. It is also often difficult to predict which sector would perform well in the future and offer high returns versus a sector that may not do well and offer low returns. For instance, the pharma sector saw a massive rally during the initial days of the Covid-19 pandemic. If an investor would have invested in any pharma company for portfolio diversification, he/she may have made substantial profits. On the other hand, the real estate market saw a slowdown and resulted in lower returns for investors.
- Improved and consistent portfolio returns
Many investment areas, like the stock market, real estate, etc are highly volatile. Therefore, just focusing on investment in either stocks or real estate may not offer consistent returns in the long run. It is therefore important for investors to invest across different assets like bank fixed deposits, gold, and debt instruments, apart from stocks and real estate, to bring a balance and consistency in investment returns.
- Higher liquidity
Many people often allocate substantial corpus to safer investment options like bank fixed deposits or NPS or PPF. Although these investments offer high levels of capital safety, they also come with different lock-in periods. Thus, in case of an emergency, an investor may not have the desired liquidity. With portfolio diversification, an investor can invest in different asset classes such that there are some highly liquid investments and also safe long-term investments. This way, one need not pay a penalty for liquidating an investment during financial emergencies.
Factors to consider in portfolio diversification
Portfolio diversification offers many advantages, however, it may not be everyone’s cup of tea. If it is not executed correctly, it may end up costing a lot. Therefore, for investors who are not well-versed with the concept of diversification, it makes sense to consult a professional. Also, investors must check the level of diversification that may be suitable instead of going overboard with it.
Conclusion
Portfolio diversification is the answer to one of the most commonly asked questions in investment, that is, how to manage the risk factor. It allows an investor to enjoy some peace of mind when it comes to the overall risk of investment. Also, one can be confident about fetching some returns on overall investments even if a few of them are not performing well.
FAQs
A portfolio is well-diversified if it allows sufficient exposure to different asset classes and adapts to the investor’s investment horizon, risk profile and financial goals.
If a portfolio is over-diversified, it can cause complications since exposure to too many assets can make it difficult to manage the portfolio. Over-diversification can also result in a risk of lower returns and low liquidity.
One can save taxes through portfolio diversification since it allows exposure to assets that either allow tax deductions or exemptions on returns generated.
Risk-averse investors can benefit from portfolio diversification, as they can ensure the right balance in overall risk levels by investing in assets that offer stable returns against assets that are highly volatile.
