Many people think of investing as just allocating capital and keeping track of their investment in the stock market. While that is important, one should undertake many other vital steps on their investment journey. And one of the most important steps is portfolio diversification.
Portfolio diversification means spreading your investments across different assets and asset classes. There are several reasons for diversification but before we explore them, let us look at the steps to diversify your portfolio.
Steps for Portfolio Diversification
To diversify your portfolio, you first need to identify your financial goals, the time you have to accomplish these goals, and your risk appetite. These three factors, along with a few others like age and income, will help you understand which assets you should invest in and how much you should invest in them. However, after you have successfully allocated assets in your portfolio your work isn’t done yet. You need to keep a close watch on your investments, keep track of their performance, and rebalance your portfolio accordingly. Otherwise, you will not be able to track bad investments and will not meet your goals in time.
Benefits of Diversification
The following points highlight the importance of portfolio diversification:
1. Protects You From Investing Risks
Investing involves a lot of risks. However, it is still necessary for securing your future and beat inflation. To protect yourself from some of these investing risks, you should practice portfolio diversification. By spreading your investments, you protect yourself from volatility in any one sector. For example, if the government suddenly reduces bond interest rates and has only invested in bonds, your returns will go down, and you will lose money. However, if you have also invested in stocks, mutual funds, and real estate, you will still be getting returns from these investments, and your profits and losses will be balanced.
2. Helps you Tap Different Sectors
When you diversify your stock investments, you invest in a couple of different sectors. You never know when one of these sectors will start performing exceptionally well and give you high returns. For example, like during the COVID-19 pandemic, the stocks of many drug manufacturing companies shot up. If you had already invested in these companies to diversify, you would have made huge profits.
3. Gives You Higher and Consistent Overall Returns
Historically, the stock market is very volatile. So, just investing in stocks can not give you consistent returns on your investment. Moreover, investing in safe assets like fixed deposits gives you meager investment returns. But if you invest in different asset classes, you can ensure you get significant and consistent returns.
4. Provides Liquidity
People often stick to safe investment options like fixed deposits or public provident funds. While these investments are safe, they have lock-in periods. So if you try to cash in on these during an emergency, you will have to pay a fine. One main advantage of portfolio diversification is that you can invest in a few liquid investments along with these safe investments, which will allow you to get cash quickly whenever you need it.
Complications of Portfolio Diversification
While there are many advantages of diversification, it is simply not everyone’s cup of tea. If not done correctly, it could also cost you money. This is why a large amount of the Indian population sticks to putting their money in fixed deposits or employer-provided retirement funds. But these investments are not always enough to beat inflation and build a retirement fund.
So, consult a professional if you want to diversify your portfolio but don’t want to spend a lot of time and effort doing it. This has now become easier than ever before. You can just go online and select a website that provides financial consultancy services. Wealth Desk is one such platform that helps you with portfolio diversification by allowing you to choose a mix of equities and ETFs.
Portfolio diversification is essential as it helps you counter one of the biggest disadvantages of investing: the risk factor. By diversifying your portfolio, you can also be at peace, knowing that at least some of your investments will give you returns if the market is not entirely favourable. Further, if you decide to use the services of a professional, investing may become even simpler and offer better returns.
Portfolio diversification can become too complicated sometimes, especially if you decide to undertake it on your own. It can also be very time-consuming and tedious. Also, if you don’t have the appropriate knowledge of the market and end up including some dubious investments in your portfolio, you could be increasing your risks rather than decreasing them.
A well-diversified portfolio differs from person to person. There is no one type of recommended asset allocation that you can follow. However, it should include three primary components: stocks, bonds, and cash. You can also add various other investments to your portfolio like real estate, fixed deposits, insurance policies, and so on. But you need to be careful and not include too many assets as these can be challenging to track and may dilute your returns.
To understand whether or not your portfolio is well-diversified, you should look at what risks your investments face. For instance, both stocks and mutual funds are subject to market volatility. So, if the market crashes, both these investments will be affected. Now, if you only invested in them, you would not be protected from investment risk, which means your portfolio is not truly diversified. The same goes for investing in fixed deposits and mutual funds. They both have lock-in periods, and so they expose you to liquidity risk. To ensure that your portfolio is truly diverse, you should ensure that not all your investments face the same risks.