Portfolio diversification is an important rule if you want to be a successful investor. Putting all your money in one particular stock is dangerous and can end disastrously. Diversification helps protect your returns and often maximizes them when you invest across different sectors and assets. These investments react in different ways and can often negate other losses in your portfolio. There are all sorts of options and ways in which you can diversify your portfolio. Here are the best five ways –
#1 Determine your needs and goals
People invest for several reasons – saving for grad school, retirement, or simply avoiding cash losing its value sitting idle in the bank. Your portfolio’s distribution will vary depending on your needs and goals. It always helps to know why you invest your money and what you will use it for. This helps narrow down your investment options and eliminates any unwarranted risks you may be exposed to. If you want to invest for longer, you can consider higher-risk assets. And if you are not looking for something too risky, it is advisable to stick to a larger fraction of, say, debt mutual funds. However, if you want to save particularly for retirement but end up investing in just stocks, there might be a chance that you will lose your money.
#2 Extend and spread out your options
When diversifying, go for variety and not quantity. True diversification is not achieved through the number of stocks you own but through variation in your portfolio. While sticking to one particular sector may seem attractive, it can be fairly disappointing for long-term investments if your chosen sector is hit with some negative news.
For example, if you truly want to see healthy returns for the money invested in the equity market, consider broadening your options, not just stock-wise but sector-wise. There should be a good mix of multiple industries, even within invested stocks. Otherwise, it often results in lost opportunities or stagnant returns. Consider investing in some cyclical stocks and some non-cyclical stores. This way, no loss will hit your portfolio too hard.
A fine example of a diversified portfolio. Image source: The College Investor
#3 Keep re-evaluating and building your profile
Financial markets are very dynamic and prone to volatility and quick changes. Hence, it is good to keep adding to your profile or re-arranging your portfolio every few years. While this can seem difficult for risk-averse folks, it can be gratifying over the long term. For example, in 2009, many investors were wary of investing in Netflix, which was nascent back then. It has delivered returns as high as 82 times in the nine years since then! It can be prudent to invest in a potential giant and invest in it when its valuation is still on the lower side. Re-evaluating could also mean removing a stock if it looks too risky to include in your portfolio.
#4 Invest in non-stock options as well
While investing in stocks is standard practice for many investors, you could dedicate roughly 30 percent of your investments to non-stock options. These include debt mutual funds, real estate, and gold, to name a few. A trendy choice among beginners is debt mutual funds. Mutual funds are pre-organized portfolios of stocks and bonds that are already diversified and professionally managed; hence, they are always recommended for first-time investors. Debt mutual funds are much less risky since they invest in far safer assets such as bonds. The starting investment is as low as Rs 1,000/- and thus has found a comfortable spot with all age groups alike, be it college students or retired people. A good place to invest can begin by checking out the offerings from HDFC Mutual Fund. It has many schemes to choose from, and it’s Top 200’ has consistently performed.
#5 Lastly, do not over-diversify your portfolio
While diversification is good, over-diversification can also hurt your investments. Several red flags can tell you that your profile has been over-diversified. One example is owning too many mutual funds within the same market-cap category (large-cap, mid-cap, and small-cap). These are investments with similar holdings and essentially reduce your rate of diversification. Owning too many stock positions could also harm your portfolio. Even though it isn’t a rule written in stone, most advisors would say that the threshold level of proper diversification is about 100 stocks of varied sectors to diversify your portfolio. The more profitable investments do not necessarily create an impact or add value with too many stores since your capital is spread thinly among the different assets. Also, the entire idea of handling more supplies and maintaining a huge portfolio is cumbersome. After a point, over-diversification plateaus your returns and has no incremental benefits.
Although diversification does not guarantee that your investments will only see profits, it provides stability to your overall profile. Many investors would quickly point out that diversification is a primary tenet of good investment practices.
