How Important Is a Diversified Portfolio

How Important Is a Diversified Portfolio?

As a child, you must have heard tales where the moral taught you to never put all your eggs in one basket. Quite literally this translates to not putting all your eggs in one basket, cause if the basket falls, you lose all the eggs. Over the course of time, you would have realised the importance of this adage in a variety of aspects – from choosing an educational programme which offered you various job prospects to interviewing with multiple organisations before deciding on joining one. The adage offers a simple advice – be sure to have options at hand, for sticking to just one thing can cause you to lose a number of potential opportunities. This holds especially true in the new normal, where people are keen on exploring themselves and finding new avenues to upskill. Indeed, the more relevant and varied your skill sets, the better are your prospects. This is called diversification and the childhood advice comes in handy while taking investment decisions too.

The term portfolio diversification refers to this concept – you should not put all your money in one asset, just like you should never put all your eggs in one basket. However, just putting each egg in a different basket is not really feasible – you should have a strategy in place, which helps you ascertain how the eggs should be diversified for optimal results. The case with investing is quite similar – portfolio diversification should not be focused merely on buying multiple investments. The strategy should take into account aspects such as your risk profile, your return requirement, financial goals, and time horizon, as these form the basis of an optimal portfolio diversification strategy.   

How to streamline your portfolio diversification strategy?

When you enter the labyrinth that is investing, you will be inundated with a variety of options and sub-options – from real estate to debt, equity, commodity, and even cryptocurrency. Each of these asset classes have sub-categories. For instance, if you pick debt, you have to then choose from government bonds, corporate bonds, commercial papers, debt mutual funds, etc. You also have to contend with various types of risk like credit risk, interest rate risk, duration risk, etc. This plethora of options makes it difficult to streamline your portfolio diversification strategy and may even lead to the fear of missing out on potential opportunities. Does that mean you should divide your wealth into all these categories? Absolutely not, for, the more you divide your money, the less your corresponding returns will be. An optimal portfolio diversification strategy should comprise of a few choice asset categories which best align with your personal investment ethics and requirements.

Let us consider an example here. Suppose you are in your late 20s and in possession of INR 5 lakh. You want to invest this amount for a period of five years and, at the end of the five-year period, you want this money to turn to about INR 10 lakhs. Your main goal here is to purchase a car at the end of the 5 year period. In this scenario, what you are ideally targeting is a rate of return over 15% which means that your portfolio diversification strategy should be focused on equities. Now, at your age, it is safe to assume that you have a long career ahead of you, allowing you to withstand considerable risk in the quest for high returns. Thus, an optimal portfolio diversification strategy here could entail the following – parking about 70% of your money in high risk, high return options like equity funds, allocating 20% to safe and stable debt funds, and investing about 5% in hedging assets like gold, and keeping 5% as cash in bank. The high exposure to equities could potentially boost your portfolio returns while the 20% exposure to debt would, to a certain extent, act as a security blanket during equity market falls, thereby allowing you to withstand major market crashes. Further, the five-year time horizon allows you time to overcome potential market slumps, putting you on track to achieving your financial goal at the end of the tenure.

Now, let’s take you a decade ahead. You are in your late 30s, have a young family, and are paying off a car loan. Your earning potential is still strong but your liabilities have gone up. Additionally, you need to prepare for future cash outflows to fund your children’s further education and also create a nest-egg for your retirement. At this point in time, a 70% exposure to equities may not be appropriate. Thus, the meaning of an optimal diversification strategy changes for you.

Things to keep in mind 

One of the most important things to keep in mind, when creating an optimal portfolio diversification strategy, is the fact that no two investors are the same and the meaning of ‘optimal’ changes with changing circumstances and market scenarios. While one of your friends may have financial plans that include purchasing a house ten years down the line, another may be investing to create funds for international travel. Since each individual has different investment metrics, you must never blindly follow suit. Work towards creating your own, personalised investment strategy, aligned to your individual risk appetite, time horizon, financial goals, and return requirement, instead of going with the flow. Once you have a strategy in mind, stick to it through thick and thin. Many a times, young investors get swayed by emotions such as fear, greed, and anxiety and this may lead you to take illogical decisions. Avoid such traps at all times and keep your vision focused on the goal ahead.

The investment world is confusing and frightening, there is no doubt about it. However, if you have a sound portfolio diversification strategy in place, created in line with your personal metrics and requirements, you need not worry about temporary market slumps. Just stay invested for the pre-decided time horizon and see your investment reap the required returns!

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