Do you remember the hide-and-seek games you would play as a child? The idea was that each kid would hide in a different spot so they wouldn’t all get caught together. If everyone was caught, it was game over. Well, that is precisely what diversification is all about.
Imagine what would happen if we you were to invest all your money in one financial instrument. As long as the market performed, all would be well. But as soon the market fluctuated against your advantage, you’d stand to lose all your savings in a single blow. This is why it’s important to diversify your investments.
What is portfolio diversification?
Portfolio diversification is a portfolio management strategy wherein you invest in different securities and assets so that if the market fluctuates, you do not lose all your money. The primary goal of diversification is not to maximize returns but to safeguard your portfolio from the impact of volatility.
When you build and manage your portfolio, regardless of the goals you are pursuing, there are two main factors to consider:
- The time (in years) that you are expecting the need for the money, i.e. the time horizon
- Your risk tolerance, i.e. your risk-taking capacity
The idea here is the same as the adage – “Don’t put all your eggs in one basket”. When you are invested in a variety of assets, even if one of those fails, the remaining will ensure that your portfolio remains secure as a whole. This added security to your portfolio can be measured by the increase in profits that a diversified portfolio delivers when compared to an investment (of the same size) in a single asset.
Main components of a portfolio
Shares or stocks are as the highest-risk component of your investment portfolio. On the flipside, they give you the opportunity for high growth. This asset class’ potential for growth brings with it great risk as well, especially in the short term.
Bonds, in most cases, provide regular rates of interest rates and are less risky than shares. Also, they tend to act as a buffer for the fluctuations in the stock markets as bonds function in a different manner compared to equity.
Money Market vehicles
These include money market funds and certificates of deposits (for example Fixed Deposits). These short-term investment vehicles are low-risk instruments. They are ideal for investors looking to preserve their principal amount. For the level of safety guaranteed in the money market, these instruments generally provide lower rates of interest when compared to shares and bonds.
Another way to counter the highly unpredictable stock market is to include mutual funds in your portfolio diversification strategy. Here, you contribute to a pool of funds that is managed by professional investors, and can invest in various asset classes – equity, bonds, gold, real estate, etc. Systematic Investment Plans (SIP) are a particularly popular option amongst investors wherein you invest in a regular and disciplined manner. On the other hand, some investors choose to invest a lump sum.