Diversification is a risk mitigation technique by allocating assets across different financial instruments, industries, sectors, and several other categories. The idea behind this strategy is to eliminate the risk of being in the wrong market at the wrong time and maximize the returns.
The purpose of diversification is to balance out the unsystematic risk in the portfolio which means that the negative performance of an asset class gets neutralized by positive performance. Although diversification does not provide any guarantee against loss, it is the most significant element of achieving long-range financial goals while reducing risk.
Investors and fund managers generally diversify their investments across different asset classes and evaluate what portfolio percentages to assign to each.
Asset classes such as-
Stocks: Equities or shares of a publicly-traded company
Bonds: Government or corporate fixed-income debt instruments
Commodities: Basic elements needed for the manufacture of final products/services
Exchange-Traded Funds(ETFs): It is a collections of securities that follow an index, commodity, or sector and are listed on exchanges.
Cash: Treasury bills, money market vehicles, Certificate of Deposits and another low risk, short term investments
Real Estate: buildings, land, natural resources, livestock, agriculture, water, and mineral deposits.
What is diversification in mutual funds?
Diversifying one’s assets into various types of mutual funds based on the investor’s risk profile and investment objectives.
Various options in mutual funds. The broad categories are – equity mutual funds, debt mutual funds and gold funds. These categories have different levels of risk, equity funds have the highest risk, debt funds and gold funds also have some level of risk.
Moreover, among equity funds, large cap funds are less risky than mid cap funds. While in case of debt funds, corporate bond funds are riskier than those that have more exposure to government securities.
How to diversify your portfolio?
Check your risk appetite
The primary step for diversifying your portfolio is to understand your risk appetite. Risk appetite means how much money an investor can afford to lose. Investors with high-risk appetites can stomach market fluctuations and be able to sail through such situations they investor has liquid money parked in some other asset class. Losses are just on paper unless investments are redeemed.
Match risk appetite with goals
The investor should pick securities aligning with their goals and as per their risk appetite. Every investor diversifies his/her portfolio differently as everyone has different goals and risk appetite. For example, A risk averse investor will diversify differently than a risk taker.
Building a portfolio
As mentioned above, the investor should build his/her portfolio by investing in different asset classes such as stocks, bonds, gold and more. This approach will help the investor to better ride the volatility.
Pick from different industries/ sectors
Diversification also constitutes picking stocks from different industries. So, this means that if the stocks you pick are from the same sector and if there is a market correction then the value of your portfolio can come down. To avoid such risk, it is critical to pick stocks from different industries which can help to compensate for loss.
Study about the fund manager
For a solid performance of the mutual fund scheme, the fund manager’s skill and experience play a very big role. As the fund manager decides where and when to invest.
Why is it important for investors to diversify?
To build a strong portfolio, it is of utmost importance to diversify your investments. Here are the advantages of diversifying your portfolio:
- A well-diversified portfolio is better to absorb the shocks during market turndown as the risk is well spread out.
- For better risk-adjusted returns it is imperative to have a well-diversified portfolio
- By investing in various asset classes, one can leverage the growth opportunities present in those asset classes.
- One gets to learn about different investment choices while diversifying
One gets to learn about different investment choices while diversifying
Diversification is essential to avoid the risk of investing in only one kind of asset. But many times it happens that the investors over-diversify their portfolio which is very damaging for the investors. A portfolio is said to be over-diversified when the marginal loss of expected return is greater than the marginal benefit of reduced risk. This means that the returns are reduced without a meaningful reduction in risk.
In mutual funds, if a fund invests in more than 100 stocks that does not mean that the fund has optimum diversification. At times it might be difficult for the fund manager to get the alpha. Having too many funds in your portfolio can reduce the gains.
To avoid the concentration risk- the risk of putting all your money in one investment, it is important to diversify. While on the other hand, if you invest in 2-3 different investments, you can reduce your concentration risk. Also, diversification does not completely eliminate the risk, but it surely helps to reduce the risk.