Most investors tend to focus on keeping their savings in a particular investment or asset class. For some investors it is gold, for some it is fixed deposits and for others it is stocks. However, concentrating your savings in one asset is a risky proposition. If the investor’s favourite asset gives poor returns, then his efforts at wealth creation would face a setback.
Diversification is a strategy that aims to prevent such an outcome by spreading investments among different assets and investments. The idea is that the higher returns from some investments would offset lower returns from other investments. As a result, the overall risk of the portfolio is reduced.
The simplest way to diversify is through asset allocation. This means spreading your investments across a range of asset classes such as stocks, debt, cash, mutual funds, bonds, real estate and gold in a systematic manner. That way, if equity markets give poor returns, you can offset it with gains from investing in fixed income and gold.
The ideal asset allocation for an investor depends on the investor’s risk appetite. The higher the risk appetite of the investor the higher proportion of his investment should be in equities. In order to determine your risk appetite, you should consult an investment advisor who can guide you on the details.
It is also important to remember to diversify within asset classes as well. This is especially true regarding equity investments. It is important to remember that while buying equities is an important part of a diversified portfolio, holding similar stocks is a risky practice.
IT stocks had given investors great returns during the period of 2013-2015 (an annualised return of 31%). However, the performance for the sector from 2015 onwards has been negative with an annualised return of around -3%. Investors who manage their own stock portfolios need to avoid concentrating into any one particular sector or stock to avoid such a situation.
Diversified equity portfolio
One way to have a diversified equity portfolio is to invest through equity mutual funds. Equity mutual funds are managed by investment experts who ensure that the holdings of the fund are diversified across different sectors. By buying an equity mutual fund, an investor gets the benefit of owning a diversified equity portfolio that is also actively managed by investments experts.
Diversification is a tool that helps all types of investors—from the small-time individuals to the largest institutional investors. Until a few years back, it was hard for individual investors to reliably measure whether their investments were appropriately diversified. However, with the introduction of digital advisory solutions investors can now conveniently diversify their investments. Diversification is quite possibly the only free lunch that exists in the market and investors should take advantage of it to ensure that their capital grows smoothly.
The author is head of research, Angel Broking