Diversification is an investor’s best friend in times of volatility. Here’s why

By: |
May 19, 2021 9:40 PM

Despite stable performance of the companies in which investments are made, the market value of the shares would fluctuate along with the fluctuation in equity markets.

Diversification, market volatility, equity investment, market risk, default risk, stock market, Risk diversification, liquidityHigher the market volatility, higher will be the fluctuations in stock prices and higher will be risk and opportunity to earn return.

Investments in equities are considered as risky. This is because the equity investors are treated as owners of a company having ownership in proportion of share held in the company. So, in case of liquidation, an equity investor will get money, if any, in proportion of shareholding only after all the liabilities are cleared. As a result, there is a risk of losing the entire capital invested in case of default.

So, as it’s said not to put all the eggs in the same basket, as one rotten egg may spoil all the eggs, it’s also said not to invest the entire money in the stocks of a single company, as in case of default, the investor may lose the entire capital.

To minimise the risk, investors need to invest in different companies, so that even if one or two companies close down, money invested in other companies would continue to give returns.

However, investing in different good companies in a diversified way doesn’t make the investments in stocks stable, as apart from default risk, equity investments are also subject to market risks.

So, despite stable performance of the companies in which investments are made, the market value of the shares would fluctuate along with the fluctuation in equity markets.

Although the stock markets provide liquidity, allowing the investors to buy and sell stocks freely during market hours, the market volatility affects the value of the stocks, especially in the short run.

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Higher the market volatility, higher will be the fluctuations in stock prices and higher will be risk and opportunity to earn return.

“Risk diversification is the best way of migrating risks associated with market vagaries. Stocks perform on the basis of companies performance. Future prospects and sectoral outlook individual stocks react to market and Sensex differently,” said S Ravi, Former Chairman of BSE and Founder & Managing Partner of Ravi Rajan & Co.

However, a well diversified investment portfolio may absorb some volatility, as stocks of large-cap, mid-cap and small-cap companies may fluctuate differently.

“From a investors perspective it is essential to mitigate the risk by investing in many stocks. Some company stocks tend to be volatile and some consistent. Investors generally buy shares which have a good track record for paying dividends,” said Ravi.

So, higher diversification would ensure higher portfolio stability.

“A portfolio of stocks is always a more prudent way of investing. Liquidity is another considering a basket of shares as liquidity in some investments may be an issue. A diversified portfolio is the best method of investment. Even fund managers of mutual funds follow the principal in order to overcome concentration risks. However it is important for any investor to buy shares to the extent they can closely monitor,” said Ravi.

So, in case, it’s become difficult for a retail investor to invest and manage many stocks, it’s better to invest in a equity-oriented mutual fund (MF) with a well diversified portfolio to withstand market volatility.

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