Betting all your money on one horse is nothing more than a gamble. You either earn everything or nothing. Though it’s not the same (everything or nothing) with investments, the exposure to risk can be largely reduced if you learn how to diversify an investment portfolio.
What is Diversification of Investment Portfolio?
Diversification of an investment portfolio is a strategy that utilizes different asset classes, investment vehicles to minimize risk and maximize returns.
Though diversification might yield a higher return in the long run, it is a risk management strategy that minimizes the risk against market conditions and industry/sector fluctuations.
Having the eggs laid in more than one pot will help reduce the exposure to risk within the asset class and across asset classes. Also leveraging the opportunity to reap the best returns from various investment classes in the long run.
Understanding Diversification of Investment
Consider yourself owning equity of company A for $1000 and the quarterly sales dipping all time low. The stocks are beaten down to 50%. So your investment value becomes $500 – 50% loss. Investing $500 in company A and $500 in Company B in the same scenario will lead to a loss of $250 with $750 in hand – 25% loss.
Now, the same scenario except you have invested your $1000 in Company A – $200, Company B – $300, Company C -$100, and Company D – $400. Now the 50% fall in company A stock price will only eat a $100 of investment value which is just 10%. This 10% in loss to is compensated by profits from other investments if analyzed and invested wisely.
Diversification helps elude unexpected losses by reducing risk exposure to one asset or asset class. The investments within a portfolio need to balance out the other in case of unforeseen risks for the diversification to be effective.
To achieve the best outcome through diversification, you need to assess the risk and returns of the investments and plan in an opposing way within and across asset classes. So here are some common ways to diversify your portfolio.
Diversification across Asset Classes
Diversification across asset classes is the most common and basic investment strategy for the best risk to reward outcomes achievable with the least financial knowledge. Of the five main asset classes – Cash, fixed interest, equity, property, and commodity investing in at least 3 should reduce risk exposure to a good extent.
From a border perspective, asset class diversification doesn’t guarantee much higher returns, it strengthens against the undulations of the market. However bad the equity and real estate performs due to market risk (systematic risk) asset classes like fixed interests are guaranteed to return a minimal interest rate.
Diversification within an Asset Class – Equity
The concept of diversification within an asset class works best in equity. They work best to reduce exposure to unsystematic risk – risk caused due to a company’s poor performance or the sector/industry’s downfall.
Simply by investing in different companies from various sectors unsystematic risk is kept in check.
There is another way to diversify investments within an asset class – based on market capitalization. High market-cap companies are generally low risk and low yield.
On the contrary, low market-cap businesses are high-risk but yield higher returns. Choosing a mix of low-cap and high-cap companies based on your risk appetite helps reduce risk.
Diversification within asset classes also applies to other asset classes like splitting across different commodities and investment vehicles.
Diversification across Markets
Systematic risk risks are mostly tied to the market (country) hence institutional investors often invest a part of their portfolio in foreign markets in the form of shares, REITs, or debt investments. Foreign investments are a great opportunity for high returns with the choice of markets let to you.
Diversification based on Risk Appetite
This is the crucial part of diversification that everyone must consider. But it is hard to implement unless you have a financial background.
Putting together a portfolio based on risk appetite makes sure you make enough returns for your short-term goals and take a planned risk with the best probability of high returns. The percentage of high-risk vs low-risk investment can be planned only based on the investor’s short-term and long-term goals.
How to Diversify An Investment Portfolio?
1. Find your Investment Goals
Investing for a purpose yields a better-structured investment portfolio than simply investing in the easily available avenues. So start with accessing your needs – both short and long term.
Even if you are not sure about the exact expense in a particular time period, something like a children’s higher education fee in the 10th year will give you a rough idea. Make a timeline of goals along with the returns you are expecting.
2. Find your Investment Capacity and Risk Appetite
Now access your investment capacity and do a rough projection of your investment with an average rate of return. Factor in inflation and career growth to get a clear picture.
If your current investment capacity exceeds your goal, you have a good risk appetite, if not, look for ways to increase your investment cut-off every month.
3. Pick and Classify the Investment Opportunities
List the investment options that are available to you along with the duration, risk, yield, and minimum threshold of investment. You might need experts’ help here.
4. Form your Diversified Investment Portfolio
Find your palette of low, medium, and high-risk investments and aggregate what works out best to meet your goals to leverage the best of the market conditions. Now start filling in your investment options as per the risk quota in the ascending order of returns. Do not remember to diversify within asset classes.
Benefits of Diversification of Investment Portfolio
- Reduced risk exposure.
- Higher returns in the long run.
- Planned risk-taking capability on high-risk high-return investments.
- Higher chances of meeting financial goals.
Drawbacks of Diversifying Investment Portfolio
- Comparatively reduced returns in the short term.
- Might lead to higher transaction costs when a smaller investment is split into many avenues.
The drawbacks are minor when most of your financial goals are long-term. But what about the days of effort you need to put in to understand and analyze investment options. If you feel that is a lot, look at investment funds like Mutual funds and Private Equity Real Estate Investment vehicles.
They diversify from within and actively manage to bring down the risk to the lowest possible level and make good profits, usually higher than the market.