What is Diversification and it's Importance?
Created on 05 Aug 2020
Wraps up in 5 Min
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Updated on 24 Aug 2022
Have you tried answering all the questions in a test for which you never studied? Well, the probability is that you will get at least one right. That's the power of diversification. Be it your exams or stock markets; it will surely save you during times of crisis. Diversification is an act where investors make investments across different asset classes in such a way as to reduce risk and improve returns.
Importance of Portfolio Diversification
Having won a lottery, you and your friend want to put your luck to a further test. So, both of you proceeded to bet on horse racing. Both of you handled different strategies. Wanting to minimize the losses, you divided the money into four parts and held the bet on four different horses. Your friend built his entire hope on a single horse and ultimately lost his entire money.
To be honest, it's not luck that saved your money over your friends, but the powerful mantra of "diversification." Like the race, the share market can be easily influenced by a number of external factors that have nothing to do with the company you are holding. From trade tensions to COVID-19, from border issues to sudden tax changes, anything can have a huge impact on the markets.
Those risks which are beyond our control or that of the company are called systematic risks. All these risks are intractable, and we cannot escape from them. The only way to offset the losses is to wear a helmet. Or to simply state, seek the help of Portfolio diversification.
Different asset classes perform differently under any given condition. When the economy is slowing down, or there is a pandemic, you will notice that gold and bonds perform better than the rest of the asset classes. On the other hand, when the economy is climbing the ladder of growth, you might want to go in for equities. Because they always out-perform the debt and bond-based products when the markets are favorable. But the problem here is, you will never know what goes wrong. In such a case diversifying your assets and building a portfolio consisting of different asset classes can be of great aid.
However, you will have to consider a variety of factors while diversifying. They are risk profile, your goal, time period, and so on.
A few other benefits of diversification are as follows:
Reduces the risk
As said earlier, a well-diversified portfolio acts as a protective shield during times of crisis. Further, you don't have to worry even if you make a mistake. Because your investment into the rest of the asset classes will be sufficient to meet the losses sustained and offer capital protection, say you invested into some International funds. When there was an internal crisis in the country, your international finds were left unaffected.
It allows you to explore various other asset classes. Thus, you will have a better shot at succeeding and maximizing the return. You will also be given an opportunity to allocate and reallocate the assets allowing your portfolio to use the market conditions to reap the rewards. You will be exposed to different securities and will understand their behavior over time. This, you will be able to make the best out of the given opportunity.
A list of other benefits of diversification
Apart from all the ones specified above, diversification comes with a lot of other benefits as well. Jump in to find out.
- You can have the upper hand in handling the market volatility and protecting your capital against adverse conditions.
- Owning a diversified portfolio helps you escape the drawbacks of investing in the industry and sector-specific assets. For example, picture having put all your money into tech-based equities. Now you will have to suffer the consequences when the industry incurs losses. Spreading your investments will prevent such losses.
- Helps in achieving your goals at a given time frame. Good returns and minimum risk heightens the probability of reaching your goals at a faster pace.
Above all, it keeps you away from panicking and grants your good night sleep. You will not have to worry about how the markets are going to perform.
Things to consider while diversification
- Key do spot whether or not your portfolio is diversified is to check if all of them are moving in the same direction. If it does, then your portfolio is surely not diversified. Also, remember that diversification might minimise the risk. But it does not in any way remove them completely out of the equation.
- Always take your risk, goal and time period within which you want a particular goal to be fulfilled into account. It is extremely crucial to bear all these parameters in mind and align all of your investing actions accordingly.
- Most investors simply restrict and narrow down their options. It is essential you have a broader view and look into all the asset classes available. If real estate might be the right piece of your diversification puzzle then it is essential you consider investing into them. Similarly, you might be an aggressive investor or someone ready to take home risks. But it's always advisable to store a certain per cent of your money into safe havens like gold, etc.
- Asset allocation is one of the essential tools you can use in your mission to acquire a diversified portfolio. They will help you in putting the right amount of money into the various securities.
- Is your job done with that? If you are holding onto that thought, I recommend you discard that immediately. An investor should always constantly be in touch with his portfolio. He should gauge the market from time to time and allocate and reallocate resources as when the need arises. Saving it and forgetting all about it will get you nowhere.
- Last but not least, learn from mistakes. The stock market is a perfect reflection of life itself. It teaches you a lot of things. Ensure you are a good student.
Diversification is like having two bikes in your garage. When one gives up, you can simply run to the other. Mastering this will help you to stay safe even when the markets react opposite to your expectations and when your decisions go wrong. So it's high time you think about scattering your eggs rather than placing them on a single basket. Because no one likes to fail in the exams. Isn't it?
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