Probably, you already know the principle of diversification. How? For example, street vendors sell seemingly different products such as umbrellas and sunglasses. Initially, it seems odd. After all, when would a person buy both items at the same time? Perhaps, never. And that’s the point.
Vendors know that when it rains, it’s easier to sell umbrellas but not sunglasses. And when it’s sunny, the reverse is true. By selling both the items, in other words, by diversifying the product line, the vendor can reduce the risk of losing money on any given day.
‘Don’t put all your eggs in one basket’
Spreading money among different investments to reduce risk is known as diversification, where a portfolio avoids excessive exposure to a single source of risk.
As you manage your asset allocation, consider the two main factors: (a) Time horizon and (b) Risk tolerance.
Time horizon: Your time horizon is the expected period you will be investing to achieve a particular financial goal. A longer time horizon enables taking on a more volatile investment because you can sustain slow economic cycles and inevitable market hiccups.
In that case, a higher exposure to stocks/mutual funds is more appropriate. By contrast, saving up for a college education would consume a shorter time horizon, and bonds/FDs are preferred. Over the long-term, a diversified mix can outperform conservative investment options and also avoid the higher risk of, say, an all-stock portfolio.
Risk tolerance: Whatever time horizon, keep risk level within your comfort zone. So, even if you are saving for a long-term goal, in a risk-averse scenario, consider a more balanced portfolio with some fixed income investments. Conservative investors keep a ‘bird in hand’, while aggressive investors seek ‘two in the bush’.
Understand the risks
A vast array of investment products such as stocks, bonds, gold and funds, among others, exists. Before you venture, appreciate the risks of each product and make sure they are appropriate for you. A portfolio heavily weighted in stock or mutual funds, for instance, would be inappropriate for a short-term goal such as saving for a family’s summer vacation.
Diversify between and within asset categories: A portfolio should be diversified at two levels between and within asset categories. In addition to allocating your investments among various asset categories, also spread out your investments within each category.
The key is to identify investments in segments of each asset category that may perform differently under market conditions. For example, among stocks, consider investing in different sectors.
Also, mutual funds make it easy for investors to own a small portion of many investments. You can diversify by sector (eg. Healthcare, Banking, Technology), size (small-cap, mid-cap, large-cap), strategy (growth vs dividend). You cannot beat the market by timing, so allocate, sit back and enjoy the long-term ride.
Avoid investing in only one particular stock. You always learn about those made a killing off one particular investment, but you rarely hear about hundreds more that lost their lifesavings, because of poor planning.
‘Diversify’, an art
Diversifying your portfolio is an art, because it depends on a variety of factors like your age, income streams, lifestyle, risk-tolerance. Customise by which the ratio is right for you. The basic argument in favour of diversification rests on the assumption that an investor can’t know with any certainty what type of asset is best to own at any particular time.
Not true diversification
Investing in more stocks — all in the same sector — is not true diversification. Also, because you invest in a mutual fund, you are not automatically diversified, as there are ‘thematic’ funds which invest in certain sectors. Again, let’s say, you own a small-cap MF, a tech-fund and a growth fund. If a common stock held in all these funds performed poorly, it could negatively influence on your holdings.
Finally, true diversification protects you from loss because, even if one of your holdings tanks, it won’t drag down the entire portfolio. Remember, a diversified investment strategy does not eliminate risk or guarantee success, but it can earn potentially higher returns over time.
(The writer is a former banker)