Diversification: The Why’s and How’s
You are here:
“Don’t keep all your eggs in the same basket”
We have all grown up listening to this proverb. This is not just related to the eggs, it is also important in investing as well. We invest so that we can fulfil our goals and have a happy and fulfilling life. And hence, it is important to make sure that we are able to achieve our goals on time. But investing is not a risk free process. An asset whether it is equity or debt is guided by different market forces. It is not necessary that the asset or investment option of our choice will always provide attractive returns. There will be days when it will give attractive returns and there will be days when it does not.
Diversification helps to minimise the risk associated with the various asset classes. Let’s now dig deeper into diversification, what is diversification, why we need to diversify our portfolio and how should we do it.
Diversification is investing in various asset classes such as equities, debt, gold etc. The main objective of diversification is not maximisation of profits but limiting the risk. But before we try to minimise the risk in our portfolio, we need to understand the different risks and whether we can reduce it through diversification.
There are mainly two types of risks. The first is the systematic or market risk. This risk is undiversifiable and it affects all the sectors and segments of the economy. Some of these risks stem from inflation rates, interest rates, political instability and war. It is not specific to any country or company. The second type of risk is unsystematic risk. It depends on a particular country, sector or company. These risks can be diversified by spreading your investments across various asset classes or categories. The aim is to invest in assets that will not be impacted in a similar way.
The main purpose of diversification is to reduce the risk associated with your portfolio. Let us take for instance, that you had invested all your money in a specific company and it went bust. Your entire savings will be wiped off. Now, that won’t be something that you will be comfortable with. This is the importance of diversification. If you had invested your money in other products such as fixed deposits or three other companies from a different sector, you would not have been so badly hit.
You may ask that wouldn’t we miss out if the company gave good returns. Obviously, you would. But the question here will be whether you will be willing to take such high risk. Many people would not be. Hence, it is important to diversify your portfolio among different stocks, sectors and asset classes. Think of diversification as insurance. We pay a monthly or annual amount towards our term or life insurance. We could have invested the amount to grow our wealth but we have taken insurance so that our loved ones don’t face any problem after we are no longer there for them.
Now that you know why diversification is important, let’s know how you can diversify your portfolio.
Remember that the extent of diversification depends on various factors such as age, risk profile, dependents etc. For example, you have recently started working or you are in your mid 20s, diversification won’t make a lot of sense as you may hardly have enough money after paying rent and utilities. Diversification can be broadly divided into three parts: diversification within asset class, diversification across asset classes and diversification across different economies.
Diversification within asset class means that your portfolio is concentrated in one asset class but has exposure to different types of products or securities within the asset class. For example, Naina, a 25-year old girl has invested 100% of her portfolio in equities through equity mutual funds. She has invested in one ELSS fund, a small cap fund and a large cap index fund. Her portfolio is diversified within the asset but not across assets which is fine as she has the bandwidth to take risk. Her small cap fund can be volatile and can swing anywhere between -50% to 50% and beyond. However, the index fund will not be very volatile as a large cap index fund invests in the top 50 companies and are less volatile than smaller companies. Her portfolio is diversified across market capitalisation and as a result, her portfolio won’t be impacted severely in case of a market fall.
To diversify across asset classes, one should have investments across the different asset classes. There is a simple thumb rule for your ideal equity allocation which 100 less your age. For e.g. if you are 25, your equity exposure should ideally be 75% and the rest can be allotted to debt instruments like fixed deposits or recurring account. But that would be simplifying things way too much, isn’t? So what should one do? It depends on the risk tolerance of the person and his responsibilities among other things. If the individual is willing to take risk, then there is no point in taking the 25% exposure in debt. While if the person feels that the volatility in the equity market is something hard for him to digest, then his major part of the portfolio should be in debt. Experts also recommend investing up to 5% in gold as a safe haven instrument. The important aspect is to understand the person’s risk taking capacity.
Another aspect is the number of dependents and responsibilities of the investor. Even for a 25-year old who has to financially take care of his parents and wife, taking equity exposure may be next to impossible. While the 25-year old who stays with his parents and has no financial responsibilities may be easily able to invest his entire salary into equities.
Diversification can also take place across economies. It helps to minimise risks that are associated with a particular country. For example, if you want to insulate yourself from risks that are specific to India such as currency risk or any geopolitical tension between India and Pakistan, investing in US stocks or international funds that invest in US stocks can be a better option. However, investing in stocks of other developing countries like India may not be a good option.
Conclusion: Diversification is important but it should be properly planned. Before taking the step, you should understand your requirements, your financial goals and your risk taking capacity.
Related articles:
