Portfolio diversification is an important thumb rule if you want to be a successful investor. Putting all your money in one particular stock is a dangerous idea and can end disastrously. Diversification helps protect your returns, and often even maximizes it, when you invest across different sectors and assets. These investments, which 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 their portfolio. Here are the best 5 ways –
Your portfolio’s distribution will vary depending on your needs and goals. People invest for a number of reasons – saving for grad-school, for retirement, or to simply avoid cash losing its value sitting idle in the bank. It always helps to know why you are investing your money, and what you will be using it for. This helps narrow down your investment options and eliminates any unwarranted risks you may be exposed to. If you are looking to invest for a longer period, 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 lose your money.
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 like an attractive idea, it can turn out to 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 as well. Even within invested stocks, there should be a good mix of multiple industries, otherwise it often results in lost opportunities or stagnant returns. Consider investing in some cyclical stocks and some non-cyclical stocks. This way, no loss will hit your portfolio too hard.
A fair example of a diversified portfolio. Image source: The college Investor
Financial markets are very dynamic, and prone to volatility and quick changes. Hence it is a good idea 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 very rewarding over the long term. For example, in 2009, many investors were wary of investing in Netflix – which was in its nascent stages back then. In the 9 years since then, it has delivered returns as high as 82 times! 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.
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 very popular option among beginners is debt mutual funds. Mutual funds are a pre-organised portfolios of stocks and bonds. They are already diversified and are professionally managed, hence always recommended for first time investors. Investing in a debt mutual funds is a lot less risky since they invest in far safer assets such as bonds. To add to that, 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 from checking out the offerings from HDFC Mutual Fund. It has a large number of schemes to choose from, and its ‘Top 200’ has been performing very consistently.
While diversification is good, over-diversification can also hurt your investments. There are a number of red flags that can tell you that your profile has been over-diversified. Owning too many mutual funds within the same market-cap category (large-cap, mid-cap and small-cap) is one example. These are investments with similar holdings and essentially reduces 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 acceptable diversification is about 100 stocks of varied sectors to diversify your portfolio. With too many stocks, the more profitable investments do not necessarily create an impact or add value, since your capital is spread out thinly among the different investments. Also, the entire idea of handling more stocks and maintaining a huge portfolio is cumbersome. After a point, over-diversification simply plateaus your returns and has no incremental benefits.
Although diversification does not guarantee that your investments will see only profits, it does provide stability to your overall profile. Many investors would be quick to point out that diversification is one of the primary tenets of good investment practices.