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Why is Portfolio Diversification Important? How to Diversify Your Portfolio?

When it comes to managing your investments, portfolio diversification is the key to successful financial management. Diversify intelligently to balance market volatility.

  • 5,318 Views | Updated on: Jan 10, 2024

Portfolio diversification is the process of modifying your portfolio so that your returns are not affected by sudden changes in the market. It helps you increase your spectrum of profits by allowing you to invest in different plans as per your choice.

Key Takeaways

  • Diversification is extending your investments across different asset classes to reduce risk and improve risk-adjusted returns.
  • It is important to diversify within asset classes as well, for example, by investing in different sectors or industries.
  • Diversification can help reduce volatility, provide steadier returns, and improve the risk-return tradeoff.
  • To diversify your portfolio, consider investing in a mix of stocks, bonds, cash, and other asset types.

One of the best ways of wealth accumulation is investing wisely and staying in sync with the markets. Along with amassing your wealth, this will also help you achieve your long-term financial goals. But the main question is, “What should you invest in?”. Well, there is no specific or generalized answer for this. However, one investment strategy can help make wise investment decisions: diversification.

Many financial experts believe that diversification is the key to investing, regardless of your financial goal. It may sound complicated, but it is an essential concept that every investor must follow as a principle for investment.

What is Portfolio Diversification in Investment?

Financial portfolio diversification is the process of spreading your investment around using different financial tools. It ensures that your exposure is divided evenly to every financial asset, and you could be more dependable on any of them. Diversification is a financial practice designed to reduce the volatility of your portfolio over time.

Different Types of Risk

Before we dive deeper into diversification, let us talk about the different types of risks you face when investing:

Market Risk

This is the risk associated with the overall performance of the financial markets. It includes factors like economic downturns, interest rate changes, and geopolitical events.

Specific Risk

This refers to risks that are specific to a particular investment, such as the poor performance of a single stock due to company-specific issues.

Inflation Risk

As the cost of living increases over time, the value of your money decreases. Inflation erodes the purchasing power of your investments.

Liquidity Risk

Some investments may not be easy to sell quickly without incurring significant losses. Liquidity risk is the danger of not being able to access your money when you need it.

Why is Diversification Important in Investing?

Diversification in investing helps you minimize sudden losses. A diversified portfolio allows you to combat market fluctuations in a better way. Let us explore other benefits of portfolio diversification:

Risk Reduction

By spreading your investments across different types of assets, you can lower the impact of poor performance in one area. When some investments are down, others may be up, balancing out your overall returns.

Steady Returns

Diversification can offer a more stable and predictable return over time, helping you avoid the extreme highs and lows associated with concentrated portfolios.

Lower Volatility

A diversified portfolio tends to have less price volatility, making it easier to withstand market fluctuations without panicking.

Improved Risk-Return Tradeoff

Diversification can help you balance risk and return, aligning your investments with your financial goalsa.

How to Diversify Your Investment Portfolio?

The main objective of an investment portfolio is to reduce sudden losses by increasing the range of investments. Portfolio diversification helps prevent financial damage. So, to understand how to diversify your portfolio, you must follow this 4-step guide.

Step 1: Have Multiple Investments In Your Portfolio

A well-diversified investment portfolio should have multiple investment avenues. So, it is advised to include various investment types in your portfolio and rely on more than one type.

An ideally diversified portfolio should include:

  • Liquidity/cash
  • Bonds
  • Equities
  • Stocks
  • Cash
  • ETFs
  • Mutual Funds

Step 2: Have Various Options, Even in One Individual Type

Suppose you invest in one individual type of investment, say stocks. It is suggested that even if you are investing in stocks, do not invest in a single stock or few stocks of the same sector; instead, diversify your investment among stocks of different sectors. For example, invest a manageable amount just in Tech stocks, but rather try diversifying your portfolio into auto, energy, real estate, IT, etc.

Step 3: Invest in Options With Varying Risks

We know that the main objective of the portfolio is to reduce by diversification, and thus, it is advised to invest in options with varied risks. For example, you must also have a Guaranteed Savings plan in your portfolio if you have invested in the Stock Market.

Step 4: Consider Rebalancing And Do It Regularly

Diversification is essential in investing because it helps reduce the chances of incurring sudden and heavy losses. So, it is important to maintain the ratio of the amount invested between different investment options to stay balanced and grow according to your financial goal.

Diversified Portfolio Example

Imagine you have a basket of eggs. If you put all your eggs in one basket, and that basket falls, you risk losing all your eggs. But if you distribute those eggs into multiple baskets, even if one basket falls, you will not lose everything. This simple analogy applies perfectly to investments.

A diversified portfolio is like having multiple baskets for your investments. Instead of putting all your money into one asset or a single type of investment, you spread it across various asset classes such as stocks, bonds, real estate, and maybe even some cash. Here is an example of a diversified portfolio:

  • 50% stocks
  • 30% bonds
  • 10% real estate
  • 10% cash

This portfolio is diversified because it includes different asset classes, such as stocks, bonds, and real estate. It also includes some cash, which can be used to cover unexpected expenses or to take advantage of investment opportunities. Doing this reduces the risk of losing a significant portion of your investment if one particular asset class underperforms.

Potential Problems With Diversification

While diversification is generally a smart strategy, there are some potential issues to be aware of:

Over-Diversification

It is possible to over-diversify your portfolio to the point where it becomes too complex to manage effectively. This can lead to high trading costs and limited benefits.

Correlation

If all your investments are closely correlated, they may move in the same direction during market turbulence, negating the benefits of diversification.

Reduced Upside Potential

While diversification can help protect your portfolio from significant losses, it can also potentially lower your returns. If one of your diversified assets performs exceptionally well, you will not benefit as much from that particular investment.

In the Nutshell

Portfolio diversification is a vital strategy for investors looking to achieve a balance between risk and return. While it may not guarantee the highest returns, it offers protection and stability in the face of market volatility. Remember that diversification should be tailored to your individual financial goals and risk tolerance. So, consider spreading your investments to build a more secure financial future.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

In this policy, the investment risk in the investment portfolio is borne by the policyholder.

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