To create wealth, you have to ensure that the value of your money grows over time. For this, you have to invest in such a way that the return on investment can beat the rate of inflation comprehensively without putting the capital invested in much risk.
To reduce the risk of losing all your capital, you have to either diversify your investment or invest in an investment product having a diversified portfolio.
“Diversification is key to risk mitigated wealth creation journey. Different asset classes are exposed to varied risks at different points in time. In the absence of diversification, a portfolio is likely to witness extreme high volatility. In an extreme scenario, the portfolio could witness a complete run down thereby eroding wealth in a few days, which was accumulated after years and decades of hard work,” said Pawan Parakh, Director & Portfolio Manager, Renaissance Investment Managers.
Parakh lists the following benefits that diversification provide:
Reduces impact of market volatility
Last 3 years have seen an unprecedented amount of volatility across most asset classes viz. equity, debt and commodities amongst others. Even otherwise, there is generally a crisis hitting the world economy every 3-5 years. In such an event concentrated equity portfolios would undergo a massive drawdown. Unlike this, a diversified portfolio would be far more resilient as other asset classes like debt and gold would act as a hedge. This helps in taking wise decisions which can further help in maximising returns. During uncertain times, when equities see a sharp correction and several high-quality stocks are available at attractive valuations. An investor with a diversified portfolio can capitalise on this situation by switching some allocation from debt/gold to equity. The right asset allocation can then be restored once the equity market normalises.
Ease of liquidity is another advantage of a diversified Liquidity. Investors should be cognisant of the fact that the liquidity profile is different for various asset classes. For instance, Real estate is generally a very stable asset class, however it is not as liquid an asset as equity, gold or debt. A large concentrated real estate portfolio could give steady returns but hurt badly in case of an immediate liquidity requirement.
Generates superior risk adjusted returns
A risk averse investor should also diversify the holding within a particular asset class. For instance, within the debt portfolio, the exposure shouldn’t be restricted to a few entities. It should rather be diversified across issuers and across maturities, possible. Similarly for equity and real estate as well. Putting all the eggs in one basket is never a prudent investment strategy from a risk perspective. Investors who take a systematic and disciplined approach towards investing end up generating superior risk adjusted returns, which is paramount for wealth creation in the long term.