Why Should You Diversify Your Investment Portfolio?

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Equirus Wealth

09 Dec 2022 7 min read

Risk Management#Investment#Finance

Markets are the unpredictable and primary reason which leads to volatility and instability. Famous Nobel Laureate & economist Harry Markowitz first theorized the art of portfolio selection by indicating the importance of adding uncorrelated or negatively correlated stocks to the portfolio. He says -“diversification is the only free lunch in investing”. Well, in that case, we might as well make the most of it. Here are the nuances of diversification and why you should consider it.

What is diversification?

The practice of spreading your investible surplus across multiple asset classes or multiple investment options within the same asset class is called diversification. The essence of diversification is to not put all your eggs in a single basket, as the likelihood of all eggs getting rotten in the event that a single egg is rotten is very high. This practice of diversification was first theorized by Harry Markowitz in his paper Portfolio Selection in the year 1952. However, it has been in practice for much earlier. This is a practice that is popularly used for risk reduction. Under portfolio management, typically, one carries out diversification by spreading across various asset classes, especially the ones that are negatively correlated or uncorrelated.

For example, Gold and equities as asset classes often move in opposite directions. Gold is considered a hedge against inflation. Hence, putting both these asset classes together in your portfolio will help you weather turbulent times in the market. Within a single investment avenue, for example, equity mutual funds, it could mean spreading your investment across a variety of schemes or plans which are driven by different objectives. For example, growth mutual funds aim for steady and stable returns. They tend to provide stability during a market downturn; whereas midcap mutual funds aim to provide super normal returns, they tend to outperform during the market uptrend. Having exposure to both these types of funds will help you weather different market cycles.

Need for diversification

The inherent characteristic of investing is a risk. By diversification, you can reduce your risk, and the investment spread across avenues could protect you from any extreme volatility that a particular market, investment, or sector faces at any given point in time. For example, in the year 2008, the financial crisis saw a deep fall in the real estate market, and people who held highly concentrated realty portfolios were unable to see themselves through this tough period. Other asset classes, like Government bonds and gold, offered much-needed stability at this point.

Diversification is also a factor of your risk appetite and your financial goals; the idea is to ensure that the portfolio takes a hit only to the extent that you can stomach. For an extremely conservative person, the exposure to equity or any other risky assets would be minimal.

How to diversify your investment portfolio?

There are certain steps that you need to ascertain before you embark on your journey toward optimal diversification. Without a clear plan, you may end up having a highly fragmented portfolio that may not optimize on the per unit of risk you assume. There is the risk of over-diversification and unmanageable exposure across asset classes.

  1. Ascertain your financial goals:

This is one of the first steps towards investing and diversification. All your investments should be guided by your financial goals and the timeline. The essence of investing is to ensure that your financial needs are appropriately met at relevant points in time.

  1. Assess your risk appetite:

Another important aspect of investing is to assess the quantum of a downturn that you will be able to take on your portfolio. This is not just based on your ability/outlook towards investment. It is also based on other factors such as age, type of job, the extent of job security, and the number of dependents, etc.

A bear market is often characterized by a 20% fall without a subsequent pullback. You should be aware of what this means. If you were to invest Rs. 100 and the markets fall by 20%, your investment would have fallen back to Rs. 80. To recoup the capital amount, the markets now have to deliver 25% from hereon.

  1. Asset allocation:

Choose the assets that you want to invest in, and also assess the extent of exposure to the respective asset class. The choice of assets and the quantum of exposure should not only be guided by your risk appetite but also by the timeline of your financial goals. There may be some goals that may arise in the short or medium term. Hence one needs to also look at the liquidity and taxability aspects whilst making the asset allocation.

  1. Constant monitoring and review:

Diversification is a part of the ongoing investing journey. It is not a destination. You need to consistently monitor your portfolio to ensure that the exposure to risky assets is such that it falls within your risk appetite. If there is a need for tactical or strategic realignment, then you need to accommodate the same in the best interest of the portfolio’s / investors' objective of achieving optimal returns at risk-adjusted levels.

Benefits of investment diversification:

The following are the benefits of diversification:

  1. Reduces risk:

This is one of the primary reasons to carry out diversification of your portfolio. It insulates the portfolio against extreme volatility and also helps beat inflation.

  1. Gains benefit of exposure towards well-to-do sectors/ markets:

An essential exercise of diversification is to also assess the prospects of the investment avenue. If the avenue looks promising and complements your portfolio, it should be added. There are tactical changes made to tap the intermediate opportunities that the market may offer.

For example, during Covid-19, many fund managers moved a part of their portfolio toward defensive stocks, particularly pharma and FMCG. These two sectors benefited hugely during Covid due to the unprecedented demand for drugs/hospital equipment and sanitizers etc., The strategic move not only helped in reducing the risk substantially but also optimized the returns.

  1. Stability and consistency:

Diversification offers much-needed stability and consistency in achieving optimal returns at risk-adjusted levels. The strategic realignment to your portfolio is done at all major life stages to ensure that your portfolio continues to cater to your changing financial goals.

  1. Perils of over-diversification:

One of the toughest things to comprehend concerning diversification is how much is too much. Knowing where to stop is critical as diversification, when done in excess, could be counterintuitive. It is essential to use performance ratios such as the Sharpe ratio or the Sortino ratio to assess if the returns per unit of risk remain on an upward trajectory with every element of diversification. When the returns per unit of risk start to stagnate or move downwards, it can be taken as a signal to stop diversifying the portfolio, as it may be insignificant to diversify beyond this point.

Diversification will help you weather any storm during your investment journey. It may not be a simple task. It requires adequate knowledge and information to build a well-diversified portfolio that achieves optimal returns. You can always reach out to experts to help you with this process to ensure that your portfolio continues to work towards your financial dreams most efficiently.

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