Pros and Cons of Portfolio Diversification

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Pros and Cons of Portfolio Diversification | WealthDesk

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When investing, you are often told not to put all your eggs in one basket. Simply because if anything untoward were to happen to the basket of stocks, you wouldn’t have to lose all your eggs. That’s the underlying principle of a diversified portfolio. 

You allocate your assets to different investment classes, hedging your bets in the event that one investment class does not perform, the other could counter the loss you’d make. Essentially, it is a risk management strategy. 

However, like everything else in the world, there are advantages and disadvantages to diversifying your portfolio. In this article, we will take a closer look at these to make a more educated decision when you invest.

How do you diversify your investment portfolio?

The ideal strategy for diversified investments is to adopt an approach where your asset allocation is based on your risk profile. Your risk appetite sets the tone and tenor of your investment. If you can stomach riskier investments, you can invest a larger percentage in higher risk, higher reward assets. If you are more risk-averse, you need to diversify your portfolio in a manner where your investments are better insulated. The key for an insulated investment for a risk-averse investor is to look for different assets that have historically shown other performance trends (probably not in the same direction or to the same degree).

What are the different investment asset classes for investment?

To diversify your portfolio, you can choose from a range of asset classes. Equities, which usually perform better than most assets, can be further broken down into large, mid, and small-cap stocks. Within equities, you can diversify your portfolio further (For example: based on sectors, the scale of operations, etc.). Other asset classes include fixed income instruments, such as fixed deposits, government bonds, and debentures for a steady income. They are less risky, but their returns are generally lower than returns in equities. Gold, gold ETFs, and real estate are other asset classes you can explore.

What are the advantages (pros) of diversifying your investment portfolio?

1. Risk Management: When you invest in different asset classes, you mitigate the risk you undertake. For example, suppose your portfolio diversification percentage breakdown was 50% in equities, 10% in gold, 25% in debt funds, and 15% in government bonds. In that case, if the value of your stocks falls, you only stand to make a loss on 50% of your investment to that extent (assuming other assets remain constant). It is very rare that all the investment asset classes don’t perform well simultaneously. Thus, diversifying your portfolio optimizes your returns and protects your downside in case markets are volatile.

2. Align With Your Financial Goals: Diversifying your portfolio helps you invest in different investment instruments for different time horizons. Your investment asset allocation will be based upon when you need to redeem your investments for a goal to come to fruition. For example, a long-term goal such as paying for your child’s college fees allows you to invest in equities, where you can take on higher risk for higher returns. Paying for your child’s nursery school fees is an immediate goal, for which you can invest in fixed income instruments, which are low risk with an assured income at maturity.

3. Growth Opportunity: Investing in different asset classes exposes you to growth opportunities in various sectors. For example, having a percentage of your investment in the pharma sector could earn higher returns when certain pharma companies came out with vaccines against Covid-19. Similarly, for equity investments such as investing in mutual funds. You can benefit from growth opportunities in different stocks falling in various categories based on market capitalization, such as mid-caps or small-cap companies.

What are the disadvantages (cons) of diversifying your investment portfolio?

1. More Investment Means More Mistakes Can Be Made: It is rare to get the best asset allocation for your diversified portfolio. When you try too hard to get the right mix of investments, you tend to take the risk of selecting the wrong investments, which, in turn, could dilute your returns.

2. Different Rules For Different Assets: Each asset class has a different structure and works differently. If you over-diversify, you run a chance of investing without genuinely understanding the asset and how it works. This could lead to complications and wrongful investments.

3. Tax Implications: Just like the asset classes work differently, they are taxed differently. Without proper tax planning, you tend to run the risk of additional tax compliance or higher consulting costs with a tax planner.

4. Cost of Investment: Each asset class comes with different fees and charges. This needs to be considered when diversifying your portfolio, as the fees could add up and dilute the value of your investments.

5. Capping Growth: While diversifying reduces the risk while optimizing the returns, you stand a chance to lose out on opportunities to earn higher returns when certain assets are performing well.

To overcome the challenges that come from diversifying your investments, you can invest through WealthDesk, a platform for retail investors to invest in portfolios curated by SEBI registered professionals. Be it a top-down asset allocation, where the macro-economic factors are considered, or you want to build your portfolio with assets that seem attractive and accurate for your needs, investing in WealthBaskets through WealthDesk empowers you to make the right investment decisions.

The consensus is to hold a diversified portfolio. To counter the risk of putting all your investments in one asset class and standing a chance to lose it entirely or incur an opportunity cost when another asset class does well, diversifying your portfolio is an important strategy to adopt when making investment allocations. It is equally essential to be cautious when diversifying so as not to over-diversify. 

Carry out a thorough check, ensure the asset allocation is aligned with your financial goals, be cognizant of the cost of investing, and be mindful of the asset allocation’s tax implication while building your diversified portfolio. This strategy ensures a good combination of equity, debt, fixed and liquid investments.

FAQs

What is an example of a diversified portfolio?

Diversification of a portfolio means that the portfolio holds multiple types of investment assets. A diversified portfolio comprises cash, stocks, bonds, fixed income instruments, mutual funds, property, gold, etc.

What is a well-diversified portfolio?

A well-diversified portfolio is defined as one that minimizes the risk while optimizing the returns. This is done by investing in various asset classes to minimize the weight of each asset class within the portfolio.

What does it mean to build a diversified portfolio?

Diversification of a portfolio refers to investing in a variety of asset classes within a single portfolio. It allows investors to earn higher returns while minimizing the risk of investing.

Is it good to have a diversified portfolio?

Diversifying a portfolio does help investors to mitigate the risk and reduce the volatility of one’s portfolio performance. With the market and economic factors affecting all asset classes, allocating investments across different asset classes is essential.

How do you tell if your portfolio is diversified?

If your portfolio has a combination of shares, bonds, cash, and other investment instruments, it is diversified.