We, as humans, love to have all sorts of things. Be it clothes, furniture, toys, utilities, anything. So we like it when our collection is Diversified. Diversification, as in anything other than investment & money, seems more like want and desire. But in the case of investment & money, diversification is as important as having money itself.
Table of Contents :-
What is Diversification?
The meaning of Diversification is to have different types & kinds of something. In the finance world, diversification is understood as a risk management strategy that incorporates a variety of investments in one’s portfolio.
The main purpose of diversification is to maximize returns and reduce the risk factor. It can be done by investing in different assets that tend to behave differently in the same environment. Before going deep into diversification, its importance and usefulness, let us understand Investments and Assets first.
An investment is allocating your money to buy some assets. The purpose of an investment is to generate wealth and make money work for you. Buying one or more forms of assets through money is termed an investment.
Assets can be in the form of stocks, real estate, bonds, etc. An asset is something whose value grows over time. It also has the capability to generate regular income.
A diversified portfolio purposely incorporates different types of assets. These asset types contain different risk factors, industries, investment class, etc. Let us understand this with an example –
Say you invested $50,000. You bought assets as follows –
- $20K in Tech stocks
- $10K in FMCG stocks
- $10K in Real Estate
- $10K in Government Bonds
Do you see some pattern here? The overall amount of $50,000 is split into different sectors and asset types. Say your tech stocks go down; the other three will cover it up. In case the stock market goes down as a whole, the other will cope up. Get the idea?
This is how a well-diversified portfolio helps you keep generating profits. Hence, one must have a diversified portfolio. Moreover, excess diversifying is not good either. We will be talking about it later.
Diversification Basics & Essentials
The basic idea behind diversifying your investment portfolio is to rule out any potential chance of losing money. A diversified portfolio rules out the negative returns by neutralizing them with positive returns. However, it is also true that it does not always guarantee positive returns. But surely, minimizes the loss.
In terms of stocks, a perfectly diversified portfolio of stocks, say 25 to 30, yields the maximum reduction of risk. There are times when one sector falls, and another boosts up the market. Having a portfolio of such stocks neutralizes loss and can also yield positive returns.
In short, consider Diversification as a general rule of thumb in investing. You wouldn’t be wrong if you call it a strategy. Investing in a wide variety of assets and forming a diversified portfolio is more like a strategy, after all.
Types of Assets to Diversify
Before I tell you to diversify your investment portfolio, I feel like telling you the options you have. Let us talk about different types of asset class and investment options. Generally, portfolio managers and investors diversify their or clients’ portfolio under given assets –
- Stocks – The shares of companies or equity in some public company.
- Bonds – These are mostly government instrumentalized. Bonds act as fixed income instruments of debt.
- ETFs – The Exchange-Traded Funds are like a basket. These baskets comprise shares or securities that are based upon an index or commodity sector.
- Mutual Funds – These can be termed as a broader category of Investment and diversification.
- Commodities – A commodity can be understood as a product whose trade is carried out in bulk. The commodities can be anything from an agricultural product to any natural resource.
- Fixed Deposits – It might sound weird, but your fixed deposits also account for the diversification of your portfolio. As to if all other investments go into loss, you’ll have a surety of FDs.
Diversification in Stocks and Mutual Funds
These were some of the asset classes into which you can diversify (divide) your investment. Moreover, you can further diversify in the matter of stocks and mutual funds. Say for stocks; you invest in multiple stocks of multiple sectors. For example – FMCG, Technology, Banking sector, etc. In case one or more sectors go down, the other can neutralize it.
The same is with mutual funds. Mutual funds are actually a collection of various stocks. These collections can be of multiple stocks of the same sector or different sectors. However, there is a major loophole in people’s approach to over-diversification in mutual funds. Let us carry it out with an example –
Let us suppose you have invested in three mutual funds – A, B, and C. Since you have invested in three different mutual funds, you think that your portfolio is now diversified. Now let us look into your funds’ allocations –
|Fund A||Fund B||Fund C|
Do you see something here? Have a close look at the allocations. Out of five allocations, three are common in all the funds. Now answer me – Is your portfolio really diversified? No.
Let us suppose the allocations are different but look at the sector. The majority, say 90%, of the allocations is of the Technology sector. What if the sector goes down?
Therefore, only buying different options does not guarantee diversification. A diversified portfolio is said to be diversified only when your allocations differ in the true sense.
A diversified portfolio of Foreign Entities
All the diversification options that we talked about up until now were in a nation’s context. What if you had the option to invest in foreign entities and assets. It is possible in today’s era. Suppose you are from India and you want to invest in the world’s largest corporations and companies. Such companies are usually listed in the US stock market. This way, you will hit two birds with one stone. Here’s how –
- You will have your money invested in the world’s leading corporations.
- A diversified portfolio in multi-national contexts.
But Sushrut, how is a portfolio diversified by investing in the market of different countries?
Let me give you an example – Say you have invested in ten stocks of India and ten of the US market. Now suppose the Indian economy gets a hit. All the Indian stocks go down, and so does your investment. However, your US stocks may neutralize the losses caused by Indian stocks because the downfall of one nation’s economy may not affect another nation’s market. And normally, it doesn’t.
Issues with Diversification
In a certain sense, diversifying is a boon for investments and returns. However, over diversifying can literally cause the opposite. Say you buy 100 stocks, all of different corporations and sectors. Does that make sense? Owning one stock of a company and the same for other 99. It’s nonsense. How much would you earn by doing this? Close to none.
Anything and everything are fine up until a certain limit. Above the threshold, everything becomes the opposite. The same is the case with diversification. Diversifying your portfolio is good, only up to a certain limit. You go above that, and you’ll be digging a grave for your own money.
Expensive & hard to Manage
A diversified portfolio is all great, but it also comes with certain downsides. In a diversified portfolio, you need to manage and look upon multiple investments and classes. This makes managing the portfolio a little troublesome.
Also, the more diversified portfolio you make, the more you’ll have to buy different investments. Therefore, creating a diversified portfolio proves to be a bit expensive than a normal portfolio. You may also need to hire a portfolio manager, which will cost you money too.
The investment and market world is now more equipped with numerous artificial assets and products. This makes the market more complex for beginners. Especially for those who want to build a diversified portfolio.
This is a fact. And I’m being very serious. Nothing in the investment world offers a guarantee of returns. Be it stock market, mutual fund, bonds, real estate, or anything. No matter how strongly diversified your portfolio is, it doesn’t guarantee a fixed return. Neither does it offer a guaranteed counter of risk factors and losses.
In this article, I have talked about diversification, its uses, importance, and problems too. The takeaway that you can have from this article is that – you should never invest all your money in one place or sector. Diversifying is important as it lowers your risk of losses.
There is a famous saying – ‘Never put all your eggs in one basket’
Because once the basket falls, all eggs will be shattered. The same is with money. If you invest all your money in the stock market and the market falls, all your money will be gone for good. The moment you diversify, you lower the risk of losing all your money.
Therefore, diversify, but don’t forget to refrain from over-diversifying. More in an upcoming article. For the time being, follow me on Twitter to get interesting tweets on Finance, Investments, and Minimalism!
Till then, Happy Investing!