You must have heard a lot of people mentioning the term
“diversified portfolio” and wondered what that means. A
diversified portfolio means being invested in more than one asset class. For instance, you can invest your money in
government securities, company shares, gold, silver, real estate and so on. Investment professionals suggest having
a diversified portfolio to manage risk better as the fall in one asset class may be compensated by a rise in another
if the portfolio is balanced. If all your money is invested in a single sector or scheme, you run the risk of losing
when the sector is not performing. On the other hand, if your money is allocated among different sectors or schemes,
the rise and fall can be more or less balanced and the overall portfolio might remain relatively stable.
Diversification of a portfolio is a mechanism used to participate in multiple asset classes with an aim to balance
the risks and take advantage of the cyclical movement of price in different asset classes. It gives you the
opportunity to enter and exit multiple asset classes instead of depending on one asset class to provide you with the
best returns. Diversification also gives you the opportunity to manage your short, mid and long-term financial goals
Here is how to go about creating a diversified portfolio.
The first step is to identify asset classes that have a low relation to each other. You should select assets that match your risk appetite and financial goals. You can start the basic diversification by investing in equity funds and debt funds. Later you can diversify further by adding investments in gold or silver, real estate etc
When you create a mutual fund portfolio you should add mutual fund schemes from all categories -small-cap, mid-cap and large-cap to cover a large universe of stocks. Large-cap mutual funds are known to be better performers when the market is falling, this is because these schemes invest in the stocks of large companies that are known for their consistency, while mid-cap and small-cap schemes tend to outperform during a bull market. In a bull market, the small-cap and mid-cap companies which have more room to go up tend to move faster than large-cap companies as investors tend to take more risk when the market is moving higher.
Another level of diversification is to allocate proportionately over different asset classes like Gold. Real Estate, Equities. Debt and so on. Every asset class has its own benefits. For instance, gold is considered a good investment in times of rising prices as it’s known to act as a hedge against inflation. Similarly, real estate prices tend to go up when interest rates are low.
When interest rates are high, investors prefer to move to instruments like government securities to lock in the higher rates. Whereas, when the market is falling you may invest in equity if you are seeking for wealth creation over the long term. So, you can allocate your portfolio to the relevant schemes in each asset class. You can also look at investing in hybrid funds where assets are allocated to multiple asset classes with the potential to provide the benefit of a diversified portfolio.
What are the dangers of going overboard?
Diversification helps to balance the portfolio by reducing risk. However, overdoing it will disturb the balance and reduce the returns compared to the risk. Moreover, managing an over-diversified portfolio is quite difficult and will not produce more returns. The purpose of investments is to align with your financial goals within defined timelines. If you need to exit from multiple asset classes to meet a single goal, the process will become too messy to handle.
What should you do to avoid going overboard?
It is not enough to create a diversified portfolio and forget about it. It is important to review it at regular intervals. If you feel that your portfolio is too widely spread, you may choose to consolidate so that you can manage the portfolio better. Never bite off more than you can chew. Spread your portfolio only within manageable limits else the benefits of diversification will be lost.
Do not add assets for the sake of it simply because it is low risk. It is better to evaluate each investment independently. You should make a decision to invest based on whether it can add value to your portfolio or not.
It is important to know your risk appetite and financial goals before you start investing. Investments should be well-planned so that they align with your financial goals be it long-term, mid-term or short-term. Random investments may push you into the over-diversification zone and this may reduce your portfolio returns instead of improving them.
If you find it difficult to create a diversified portfolio on your own, you should seek the help of an investment advisor who may help you create a diversified portfolio that might help you manage risks while aiming to yield optimal returns over a long time frame. You remember the old saying, don’t you? Don’t keep all your eggs in one basket. Diversify to manage your risk better but don’t spread yourself so thin that you lose control.
An investor education initiative by ICICI Prudential Mutual Fund
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