What Is Diversification? Why diversifying your investment portfolio is the best strategy?

Investing is a mix of strategic decisions that one needs to make depending on his or her financial aspirations, risk appetite and short-term and long-term goals. Portfolio Diversification is one such investing strategy that involves managing your investment portfolio’s risk profile.  It is a risk management strategy that allows you to optimize and minimize your risk by allocating your funds to different asset classes, instruments, industries and other sub-classes.

Ace investor Warren Buffett describes diversification as a “protection against ignorance”. Investing is always associated with some degree of risk irrespective of the asset class or instrument. As a general rule of thumb, higher rewards come with a high degree of risk, while low risk is often associated with low returns. Depending on your risk appetite and the type of investor you are, diversifying investment is a necessity to ensure optimum returns.

In this blog post, we will look at what is investment diversification, what portfolio diversification is, some definitions of diversification, and some basic rules of diversification you can follow.

What is diversification?

Diversification is the investment strategy of spreading your investments across different asset classes, instruments or industries among other sub-classes. This ensures that your money is distributed across multiple investment avenues and is not concentrated into one, thus balancing the risk associated with different avenues.

One way to understand the importance of diversification would be to consider a scenario without any diversification whatsoever. Say, for instance, an investor puts all his money into one asset class, say equity, one instrument, say equity stocks, and in one company. You can easily imagine the risks of such an investment. 

The said investor would be affected both by downturns in the equity markets as well as by volatility in the stock price of the particular company. History is fraught with examples of companies that were once investors’ favourites, but at a point in time wiped out investor wealth. 

For example, in India stocks of companies such as Reliance Infrastructure, DHFL, Jet Airways among many others were once the market’s favourites. Reliance Infrastructure, for instance had an all time high stock price of INR 2514, however as of 1st October 2023 its CMP stood at INR 173.25. In case of bonds, companies often default on bond interest payments. You must have heard of the Yes Bank AT1 bond debacle, where bond holders had to suffer because of the Bank’s asset reconstruction in which RBI had written-down the bonds.

Portfolio diversification effectively reduces your exposure to any one type of asset, thus reducing the volatility of your overall portfolio. A strategically curated portfolio would be a well-diversified one, with assets depending on the investor’s risk appetite and financial goals.

Diversification and financial planning

Now that you broadly understand what diversification means, let’s have a look at how you can strategically incorporate diversification into your financial planning.

Diversification entails balancing your risk tolerance with your goals in a time-bound manner. For instance, in the long run, say for your retirement savings, you would want it to be invested in relatively less volatile, secure and safe instruments, while in the short-term you may wish to invest aggressively in the short run. Similarly, at a young age you may wish to invest aggressively, while as and when you grow old, you may become a conservative investor. 

How diversified should your portfolio be? 

Again, this depends on your risk appetite and financial goals. Asset allocation involves dividing your investment corpus across different asset classes. This allocation would be different for different investors. Risk-averse investors would primarily invest in low-risk instruments or fixed-income instruments, while aggressive investors would primarily allocate a large chunk of their corpus into high-return instruments such as stocks.

Diversification strategies and asset classes

Diversification strategies depend on the level at which you are allocating your investments. You can use multiple strategies at different levels to enhance your overall portfolio diversification and minimize the risks.

🔵 Asset classes

Each asset class has a unique set of risks and rewards to offer. An investment portfolio should ideally be a mix of different asset classes with varying percentage allocations depending on the financial goals of the investor. This is exactly what fund managers do. Fund managers allocate the investment corpus to various asset classes and determine what percentage to allocate based on the fund’s features.

There are different asset classes to choose from keeping in mind their risk-reward ratio. Some of the asset classes you can choose from are equity, bonds, real estate, and alternative investments such as peer-to-peer or P2P lending, lease financing, farmland investments, etc. Each of these asset classes has different degrees of risk and reward potential associated with them.

🔵 Instruments

Even within a single asset class, there can be different instruments with different features. For instance, you can invest in the equity market either directly through equity stocks of different companies or through equity mutual funds and exchange-traded funds (ETFs). 

In bonds, you can either choose to invest in corporate bonds or government securities. Similarly, in real estate, you have the option of investing in either commercial real estate or residential real estate. 

Again, in the real estate space, you have multiple options to invest your money in. You can either choose fractional real estate, or you can buy the property as a whole. So, when it comes to diversifying investment portfolio, this can prove to be a good strategy.

🔵 Market Capitalisation (A perfect portfolio diversification strategy)

Within equity stocks, different companies can have different levels of market capitalisation, and accordingly their stock prices can be at varying degrees of consolidation and volatility. 

Usually, stocks with large market capitalisation or large-cap stocks are associated with lower risk and a comparatively lower degree of price appreciation. 

Based on market capitalisation, you can either invest in large-cap, mid-cap, or small-cap stocks. Small-cap stocks unlike large-cap are expected to grow at a faster pace. This classification can also be found in the equity mutual funds segment. 

🔵 Industry or Sector

Different industries or sectors come with their one set of risks, often called sectoral risks. While some industries are sunrise industries, others have matured and consolidated over time. 

Additionally, some sectors operate in a cyclical manner, while others have cash inflows around the year. Sectors also face the risk of sectoral regulations. Depending on global trade scenarios, different industries are hit differently by supply chain disruptions or trade rivalries at a global level. 

For example, industries that are heavily dependent on imported raw materials are likely to face the brunt of supply chain disruptions or raw material shortages elsewhere. As a result, it is always advisable that you allocate your investments across different industries and sectors.

🔵 Domestic and foreign markets

The COVID-19 pandemic and its aftermath have made it clear that different geographical markets react differently to macroeconomic forces. While the Indian economy showed resilience, markets in the West experienced a slump. 

Additionally, in this age of globalisation with multinational companies fanning their businesses beyond political boundaries, it is important that you benefit from the rise of businesses elsewhere. 

For example, the global tech giants are largely situated in the US. As an investor, you can consider investing in such multinational companies.

Conclusion

By now you must have realised the importance of diversification as an investment strategy. A well-diversified portfolio mitigates the risks associated with individual asset classes or sectors and balances the risk-reward perspectives of each investment. For retail investors, it is often difficult to diversify their portfolios considering their time and budget constraints. 

This is where mutual funds funds operated by financial institutions come in. Mutual funds essentially pool investments from multiple investors and invest the corpus in accordance with the particular fund’s features as to industry, market capitalisation, asset class, or growth prospects.

Investment diversification is crucial. It reduces the overall risk of your portfolio. In today’s age, fortunately, diversification is much easier than it was earlier. With the advent of technology-driven investment platforms, you can now easily manage your investments across different assets, and additionally, accessibility and affordability have also gone up.

However, keep in mind that it is highly advisable that you consult with your financial advisor before making any investments.