How diversification can help investors manage risk and reduce volatility

June 26, 2021 1:05 PM

Diversification not only reduces the overall risks but also tries to maximize returns over long time. This is because all assets behave differently over differently tenures.

A smart approach for individual investors is to diversify using Mutual funds. (Image: REUTERS)

By Raghvendra Nath

Diversification is a time-tested technique to reduce risk in investments. One would have heard the phrase “Don’t put all of your eggs in one basket.” In the financial world, that maxim is the quintessence of diversification. In simpler terms, diversification is the act of spreading the investments across a range of asset baskets to reduce investment risks.

Diversification not only reduces the overall risks but also tries to maximize returns over long time. This is because all assets behave differently over differently tenures. By having elements of different investment classes in the portfolio — be it Equity, Fixed Income, Real Estate, Gold, or other Commodities, a diversified portfolio tends to earn above-average long-term returns.

The need to diversify a portfolio is accentuated by a variety of reasons – and not limited to the economic environment and the macro or micro business factors. Portfolio diversification is a methodical process. Thus, a mindless diversification serves no purpose. The net effect of diversification should result in steady performance and smoother returns – never moving up or down too quickly – the reduced volatility putting investors at ease.

Main asset classes

The main asset classes in diversification include Equity, Fixed Income, Real estate and Alternative Investments. 

A smart approach for individual investors is to diversify using Mutual funds. Mutual funds are high quality investment options which are highly transparent and cost-efficient alternatives. Given the wide availability of options in Mutual fund space one can entirely build one’s portfolio only by using MF’s.

Different assets such as bonds and stocks, generally tend to have a negative correlation. Hence, a combination of asset classes is ideal for diversification benefits. A diversified portfolio across both the areas is better as unpleasant movements in one is likely to be offset by results in another.

While investments in Fixed Income could tend to reduce a portfolio’s overall returns, it could also lessen the overall risk profile and volatility. One can also venture into having some exposures into Gold as it provides a good hedge against USD depreciation.

Different sectors

Secondly, it is vital to diversify the portfolio into different sectors. This will minimize the exposure to a single economic shock and improve their flexibility to rebalance the portfolio. Diversification by industry and size is also useful for an investor looking to limit their exposure to a certain industry. It could be cyclical (financial services, real estate), defensive (healthcare, utilities) or sensitive (energy, industrials).

You will never yield the benefits of diversification by stuffing the portfolio with concentrated exposures in companies from one industry or market. Investments in different markets across the globe reduces the risks of unpredictable natural disasters or an adverse change in the political environment in a particular market severely impacting the portfolio.

It is important to note that the more uncorrelated the investments, the better it is. That way, they weather the market differently. The companies within an industry have similar risks, so a portfolio needs a broad swath of industries. To reduce company-specific risk, portfolios should vary by industry, size, and geography.

Diversification may help an investor manage risk and reduce the volatility of an asset’s price movements. Remember though, that no matter how diversified your portfolio is, the risk can never be eliminated completely. In an uncertain environment, volatile market and shortened economic cycles, it is essential to have your portfolio invested across different asset classes. Most importantly, it is recommended to take professional help in creating a portfolio. The investment professional can guide on how to systematically diversify the portfolio and look at long-term returns and mitigating the risks – both in the short-term and the long-term. The professional help can guide you to determine what level of risk is acceptable to you, and tailor your portfolio to meet that tolerance. 

Ultimately, what matters is whether you want liquidity, or if you are willing to wait it out in the long term. This will affect how your investments should be structured. Also, the risk tolerance, the investment goals and financial means of every investor is different. That plays a huge role in dictating the investments mix. Lastly, evidence-based strategies using logic and knowledge rather than emotion usually do well.

As mentioned earlier, diversification does not work the same way with every asset class across every industry in every market. Still, it is an important tool to improve risk-adjusted returns over the long haul.

(Raghvendra Nath is Managing Director of Ladderup Wealth. Views expressed are the author’s own. Please consult your financial advisor before investing.)

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