There is a common saying that goes with portfolio diversification that ‘don’t put all your eggs in one basket’. The idea is to minimize catastrophe by not putting all the resources in one place. But other than that, portfolio diversification means coloring the financial dreams and goals picture with 12 colors instead of four.
What does it mean to diversify your portfolio?
Diversifying across asset classes means investments into equities, bonds, commodities or alternatives. Diversifying an equity portfolio means investing in a combination of different stocks from different sectors. A diverse portfolio has a balanced combination of stocks from different sectors, countries, industries and others. The main aim of the diverse basket of investments is to reduce the risk over time. People believe that a diversified portfolio provides lesser returns than picking a single winning stock but it’s not true. Diversified portfolio can deliver better return if constructed objectively.
Given the coronavirus pandemic and its effect on capital markets going forward with a diversified portfolio is favorable and smart. A diversified portfolio will protect an investor against rising inflation too. Thereby it will also improve your expected rate of return. (Hence it’s not just minimizing the risk that we are talking about here)
How can one diversify their portfolio?
Whenever an investor diversifies their portfolio they have to balance their comfort level with risk against their time horizon. A diversified portfolio generally contains these components –
· domestic stocks,
· bonds,
· short-term investments,
· Gold,
· and international stocks.
Stocks are the most aggressive portion of a portfolio and provide impressive returns, but they carry a greater risk with them. Bonds are known for providing regular income and are less risky but with a lower rate of return. Bonds are also used as a cushion during fluctuations in the stock market. Short-term investments like CDs are conservative instruments that provide safety, stability and liquidity but they have a lower rate of return. Stocks that are issued by non-Indian companies may perform better than their Indian counterparts. International stocks provide the opportunity for higher returns coupled with high risk. Dedicating a portion of investment towards sector funds and commodity-focused funds provides a good hedge against inflation and different phases of the economic cycle.
What has to be kept in mind while diversifying the portfolio?
Two things- time, riskTime has to be carefully factored in while diversifying a portfolio. Every investor has a different appetite for risk hence their portfolio should reflect the same. Investing too cautiously at a young age can lead to lesser wealth creation for retirement and investing too aggressively in old age can turn lifelong savings into ash. For instance, if your portfolio has high-risk investments market volatility can be neutralized by investing in fixed income or conservative funds like bonds and money market funds.
What for?
What if one day an investor realizes that he/she has invested in a less lucrative stock?
What is one he/she realizes that money is needed earlier than expected?
What if changing market conditions calls for a different investment strategy?
This is where re-balancing portfolio comes into the picture.
Portfolio re-balancing is essentially selling some investments and buying new ones so that the portfolio matches targeted asset allocation. Re-balancing is done quarterly, annually, when allocated asset changes class etc. All said and done portfolio diversification is a simple yet smart step towards investment and wealth creation.
Do you have a diverse portfolio that caters to your risk appetite and financial goal? More importantly, are you checking it periodically?
Takeaways-
1. Invest according to your goals and risk appetite, create a portfolio that resonates with the same.
2. Periodically check your portfolio to factor out risks; re-balance if necessary
3. Maintain a balance between risk and financial goals