Rationale of Diversification

08/05/2021 2 By indiafreenotes

Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Let’s say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value.

You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that these stock prices will rise, as passengers look for alternative modes of transportation.

You could diversify even further because of the risks associated with these companies. That’s because anything that affects travel will hurt both industries. Statisticians may say that rail and air stocks have a strong correlation. This means you should diversify across the board different industries as well as different types of companies. The more uncorrelated your stocks are, the better.

Be sure to diversify among different asset classes, too. Different assets such as bonds and stocks don’t react the same way to adverse events. A combination of asset classes like stocks and bonds will reduce your portfolio’s sensitivity to market swings because they move in opposite directions. So if you diversify, unpleasant movements in one will be offset by positive results in another.

And don’t forget location, location, location. Look for opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

Purpose of portfolio diversification

 The fundamental purpose of portfolio diversification is to minimize the risk on your investments; specifically unsystematic risk.

Unsystematic risk also known as specific risk is risk that is related to a specific company or market segment. By diversifying your portfolio, this is the risk you hope to cut. This way, all your investments would not be uniformly affected in the same way by market events.

Portfolio diversification is of the core tenets of investing and is crucial for better risk management. There are many benefits of diversification. However, it must be done with caution. Here’s how you can effectively diversify your portfolio:

Spread out your investments

Investing in equities is good but that doesn’t mean you should put all your wealth in a single stock or a single sector. The same applies to your investments in other options like Fixed Deposits, Mutual Funds or gold too.

For instance, you might invest in six stocks. But if the whole market suddenly takes a tumble, you could have a problem. This problem is compounded if the stocks belonged to the same sector like manufacturing. This is because any news item or information that affects the performance of one manufacturing stock could as well affect the other stocks in some way or other.

So, even if you choose the same asset, you can diversify by investing in different sectors and industries. There are so many different industries and sectors to explore with exciting opportunities like pharmaceuticals, Information Technology (IT), consumer goods, mining, aeronautics, energy and so on.

Explore other investment avenues

You could also add other investment options and assets to your portfolio. Mutual funds, bonds, real estate and pension plans are other investments you can consider. Also, make sure that the securities vary in risk and follow different market trends. 

It has been generally observed that the bond and equity markets have contrasting movements. So, by investing in both these avenues, you can offset any negative results in one market by positive movements in the other. This way, you can ensure that you are not in a lose-lose situation.

Consider Index or Bond Funds

A sound diversification strategy, adding Index or bond funds to the mix provides your portfolio with the much-needed stability. Also, investing in Index funds is highly cost-effective as the charges are quite low compared to actively managed funds.

At the same time, investing in bond funds hedges your portfolio from market volatility and uncertainty and prevents gains from being wiped out during market volatility.

Keep Building Your Portfolio

This is another portfolio diversification strategy. You need to keep building your portfolio by investing in different asset classes, spreading across equities, debt and fixed-return instruments. Adopting this approach helps you better ride volatility.

Also, if you are investing in mutual funds, adopting the SIP route is advisable as it helps you stay invested across market cycles and gain from the concept of rupee cost averaging.

Know When to Get Out

Portfolio diversification also entails knowing the time when you must exit your investments. If the asset class you have been investing hasn’t performed up to the mark for a long period and if there have been any changes in its fundamental structure that don’t align with your goals and risk appetite, then you must exit.

Also, note that if you have invested in any market-linked instrument, then don’t exit following short-term volatility.

Keep an Eye on Commissions

This is another crucial thing to watch out for. If you are taking services of a professional, check out the fees you are paying in lieu of the services availed.

This is essential because commissions can ultimately take a toll on the end returns. A high commission can eat away into your gains.

Pros and Cons of Diversification

Now that you know the different portfolio diversification strategies let’s look at its advantages and disadvantages.

Advantages of Diversification

Makes Your Portfolio Better Shock-Proof

This is one of the major benefits of diversification. A well-diversified portfolio can better absorb the shocks during a market downturn. The risk is well-spread out when you invest in different asset classes.

Also, non-performance of one asset class is made up for by a different asset class. Simply put, with a well-diversified portfolio, you can contain the losses in a better manner.

Better Weather Market Cycles

Every economy goes through a cycle. During a cycle, markets move up, become stagnant, comes down and goes up again. With portfolio diversification, you can better weather market cycles and gain from its bullish run.

Also, following a crash when markets move up, it helps you gain from the rally. This is not the case, however, with a non-diversified portfolio that’s concentrated towards one asset class.

Enhance Risk-Adjusted Returns

This is another significant benefit of portfolio diversification. When two portfolios yield the same returns, a diversified one will take lesser risk than a concentrated one. The latter will be more volatile than the former.

Hence, for better risk-adjusted returns, it’s vital to have a diversified portfolio investing across asset classes.

Leverage Growth Opportunities Present in Other Sectors

When you invest across different assets in different sectors, you can leverage the growth opportunity present in them. For instance, of late gold has given spectacular returns and those having an exposure to the yellow metal have made quite significant gains.

Markets often see a cycle when one sector outperforms the other, and only when you have the exposure to this sector, you can take its advantage.

Provides Stability and Peace of Mind

Another significant advantage of diversification strategy is that it gives your portfolio the much-needed stability and peace of mind as you know, it can better combat a downturn. With a more predictable return, it cuts out the emotional quotient from investments, essential for achieving the desired goal.

Disadvantages of Diversification

Go Overboard

Sometimes in the name of portfolio diversification, investors tend to go overboard and end up investing in too many assets that they don’t even require.

For instance, often investors end up investing in too many equity funds holding the same stocks. This makes the portfolio bloated and dilutes returns.

Tax Complications

This is another major disadvantage of diversification. The tax structure differs across asset classes, and buying and selling them can lead to major complications. For example, taxation structure of equity mutual funds are different from debt funds. Similarly, income from bank FDs is taxed differently from that of real estate.

Hence, you need to be aware of the various tax structure while investing in different asset classes.

Risk of Investing in an Unknown Asset

Sometimes, in the name of diversification, you can end up investing in an asset that’s unknown to you. You may get caught off guard if investing in that asset isn’t legal in the country. Also, investing in an unknown asset may result in losing capital in the long run, which brings down returns of your overall portfolio.

Can Make Investments Complicated

 When you diversify too much, it can complicate investments. Before proceeding, you need to understand the structure and working of the asset class, and this can be a task too much.

On the other hand, when you invest in only a few asset classes, complications tend to be on the lower side.

Missed Windfalls

Another disadvantage of portfolio diversification is that if a single sector witnesses a spike, you can miss out on leveraging complete gains from it.

Often in the past, investors have regretted that only a small percentage of their holdings have made profits. Having said that, it’s pretty difficult to predict as to when that will happen to an asset class.