Diversification
Diversification is the process of spreading out the investment amounts across different areas so that there is a lower chance of all of the investments behaving in a similar manner. This will lead to multiple behaviours among different holdings whereby the overall volatility and consequently risk is reduced. Diversification has to become a focus point for you as an investor otherwise there could be a situation where you end up having a magnified risk on an overall portfolio level.
Diversification is also a way to inject certain type of behaviour to the portfolio. When you use just one type of asset or investment it would mean that if something goes wrong in that area there would be a significant effect on the total investment. As more and more investment options come into the portfolio there is a tendency for some of them to behave differently which will reduce the overall risk of the portfolio.
A very good example is for an investor like you to spread their money across equities, real estate and even commodities. This is diversification as compared to a situation where you just have real estate in the portfolio. In this case if the conditions in the real estate market are weak then there will be a high negative impact on you. On the other hand by having some money in fixed deposits and bonds there will be less volatility in the overall investments and at the same time there is also a possibility that some higher returns can be earned by having an exposure to equities.
Types of diversification
As an existing investor there will be an existing list of investments that you have invested into and you have to ensure that this as well as the new investments does not lead to a concentration of risk. Efforts thus will have to ensure that the portfolio and various holdings within this fulfill the role of diversification. There are several different ways in which this can be achieved so you have to ensure that different aspects are considered when deciding how to go about the div! ersification process.
Asset classes
One of the best ways to diversify your portfolio is to have an exposure to multiple asset classes. It is not a good idea to have just a single or a couple of asset class in your portfolio. If you have only equity investments then this will give rise to a high level of risk but at the same time there is also a significant risk if all the money is in fixed income or debt instruments. As your portfolio expands you should go beyond to look at options like commodities, real estate and even keep some amounts in cash. It is not just the nature of the asset but also the extent of the concentration that determines the extent of the risk present in there. Several asset classes move in opposite directions so this could be one way of ensuring that the overall risk in the portfolio is reduced. Mutual funds offer a wide range of options and increasingly some funds offer multiple options within a single scheme so you can construct your portfolio as per your requirements.
Individual holdings
There are also occasions when there could be a very high exposure in percentage terms to just a few investments. This gives rise to the risk that changes to these would determine the manner in which the entire portfolio would move. The way to tackle this position is to have a larger number of holdings wherever the investment is spread out so not only the number of holdings is large but there is a smaller percentage allocated to each of them. If you are investing in equities then you should ensure that there are around 15-25 stocks in your portfolio. A way to do this is to invest through the mutual fund route where even a small amount of investment can give you access to a larger number of holdings thus helping in the diversification process. In this example in the first portfolio just a couple of holdings determine more than three fourths of the total performance while in the second portfolio this is not the case as the share of the multiple holdings is very small individually.
Sectors
There is also a situation where the exposure to a certain sector might be quite high and this also increases the element of risk in the portfolio. An existing investor has the additional challenge of looking at all the investments in their portfolio to see whether this risk is present. At first sight this might not be visible because some of the assets could be in different forms but investing in information technology stocks and then buying mutual funds dedicated towards this sector is an example of how this risk can arise. A way to avoid this is to ensure that the portfolio amounts are not concentrated in a specific sector but are spread out across different ones. The blue line shows that concentration of risk in a sector leads to a magnified loss when things are not going well while a diversified holding manages to keep its head above water during the same time.
Market capitalisation
There are different types of companies that are present in the economic landscape. Large companies in terms of its sales and profitability are likely to have a larger market capitalisation then the smaller ones. Often companies with a similar kind of market capitalisation have a similar behaviour in terms of its conditions and its price movements. For example a tight credit situation in the economy could hit small companies harder in terms of a higher cost of borrowing as compared to larger companies as these would have wider option to raise funds. Constructing a good portfolio should ensure diversification through reducing the exposure to different companies of a similar type and size.
Reduced volatility
Mutual funds have an ability to ensure that there is a proper way in which diversification takes place. There is limited exposure to a single holding within the mutual fund. The funds also disclose the extent of exposure to a particular sector so you can see where the funds are being invested and whether this risk is acceptable to you given your specific goals and financial position. It has also been historically seen that there are various asset classes like gold and equities that do not necessarily move in the same direction at the same time. The standard deviation of various categories of funds gives an indication of the type of benefit that the diversification allows individuals. Mid cap funds have a bigger volatility than large cap funds while debt funds have low volatility. This clearly gives an indication of the kind of volatility that will come along for you as you invest in mutual funds and this will be lesser or higher as per your ability to bear risk.
Why diversification makes sense?
Achieve long term goals
As an existing investor you have to ensure that your portfolio is growing to achieve the goals that you have set. The economic environment can change quickly and concentration of risk can prove to be costly in case developments go against expectations. Diversification is a way to protect against this kind of situation. It will also aid the process of long term planning increasing confidence of investors over a period of time.
Tackle unpredictability
Various markets are also uncertain and it is difficult to predict the direction in which specific assets will move. Avoiding this difficulty is possible by diversifying across and within a range of asset classes so that there are balancing factors that are at work at all times. This will reduce the pressure to predict what will emerge as a winner and lead to an orderly way of investing.
Matching expertise
As an investor it is difficult to spend hours in trying to analyse the possible developments in the various markets while managing your money. Ensuring adequate diversification is a good way to ensure that you do not have too many eggs in a single basket. Also using mutual funds to achieve your objective will enable you to shift the responsibility to professionals.
How should I tackle this situation ?
Look for opportunities to diversify your portfolio at all times. Choosing a mutual fund for your investment needs is a small step in this direction but efforts are still required to select specific funds so that there is also diversification within the mutual fund holdings. Consider all opportunities whereby risk can be reduced as this will ensure ability to concentrate on important areas to achieve your goals. Selection of different asset classes like equities, fixed income, commodities, real estate and cash can help you in your diversification efforts. Even within each asset classes check and see that there is spread out of the investment amount. Ensure that monitoring is an integral part of your investment activities and while monitoring check for the extent of concentration of risk and whether there is adequate diversification in the portfolio.
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